MEASURES OF LEVERAGE

Suppose you want to buy a share costing $1000 and you have only $600 with you. You
will borrow the remaining $400 at some interest and invest in the stock.

PROFIT 300
EQUITY 600
Suppose you sell the stock after 1 year for $1300, your return is:
= 50%

300
If you had invested the entire $1000
yourself, your return would have been:
1000

= 30%
 Profit - Interest 300 - (400*0.1)
Let us suppose, you borrowed money @
Equity 600
10% interest. Calculate the net return.

260
600

43%

If the share price fell and you sold it at $800, your Profit - Interest -200 - (400*0.1)
net return would have been: Equity 600
In this case you incur a loss, and you also have to pay
the interest. So you are losing money in both the ends. -240
600
So leverage increases your profits, but even magnifies
your loss. -40%
CO. has no interest payments and the financial parameters are given below, observe how ROE
changes if Operating Income Changes. Company is financed using 100% equity i.e. $500 Equity

The Co. has no debt, so

EBIT Less 10% Expected EBIT EBIT Plus 10% no interest payments.
EBIT 90 100 110
Net Income
Interest expense 0 0 0 ROE =
Equity
Income before taxes 90 100 110
Taxes at 40% -36 -40 -44 We observe that the ROE
increases proportionately
Net income 54 60 66
with an increase in EBIT.
Shareholders' equity 500 500 500
If EBIT increases by 10%,
Return on equity (ROE) 10.80% 12.00% 13.20% ROE increases by 10% if
Change in ROE -10.0% 10.0% there is no interest
payment.
If Co. is financed using $200 debt and $300 equity and if we assume interest payments
are $25 every year, observe how changes in EBIT impacts ROE.

EBIT Less 10% Expected EBIT EBIT Plus 10%

EBIT 90 100 110
Interest expense -25 -25 -25
Income before taxes 65 75 85
Taxes at 40% -26 -30 -34
Net income 39 45 51
Shareholders' equity 300 300 300
Return on equity (ROE) 13.00% 15.00% 17.00%
Change in ROE -13.3% 13.3%
Observations –
• ROE increases when we use Debt Financing (Leverage).
• Though NI goes down, shareholders’ equity has also gone down.
• We also pay less tax when we raise debt and make interest payments.
• Leverage makes ROE volatile. EBIT is changing by 10%, but ROE is changing by 13.3%
Leverage, here, refers to the amount of fixed costs the Co. has in the form of operating expenses
(lease payments) or financing costs (interest expense).

Variable costs are directly related to sales. Fixed costs (periodic lease payments) are incurred
regardless the level of sales.

Business risk refers to the uncertainty about generating sufficient revenue to meet expenses. It
is a combination of:
1. Sales risk = uncertainty about sales
2. Operating risk = higher FC compared to VC that render revenue insufficient.

Financial risk = risk faced by shareholders when Co. borrows debt. Interest payment is a fixed
expense, and greater the proportion of debt, greater the financial risk.

Leverage increases risk for the equity holders, but it also increases profits.
 DEGREE OF OPERATING LEVERAGE (DOL)

Measures the % change in Operating Income (EBIT) given a % change in Revenue (Sales).
If DOL is 2, it means that if Sales increase by 10%, EBIT will increase by 20%.
Higher the DOL, higher the risk.
Cos with higher ratios of FC to VC have more operating Leverage.
It measures how effectively a firm utilizes its FC to generate better returns – once the FC is covered,
revenue from additional sales goes directly to increase the EBIT.

Sales – TVC = Contribution Margin

Sales – Total VC – Fixed costs = EBIT or Operating Income.

If there were no Fixed Costs, DOL would be = 1.

Calculate the DOL for both Cos. Given the following info:

Co A Co B
Units produced 20000 20000
Price 5 5
Variable costs 3.5 3
Fixed Costs 15,000 30,000
DOL 20000 (5-3.5) 20000*2
20000*1.5 – 15,000 10000

The results indicate that if A has a 1% increase in sales, EBIT will increase by 2% and for B, a 1% increase in
sales will increase EBIT by 4%.

But if sales decrease by 1%, EBIT of Co. B will reduce by 4%.

High amount of FC is beneficial only when the firm is able to produce and sell more no. of units.
 Co A
DOL of Co. A is 2 – So, A 10% increase in sales will lead to a
Units produced 20000
20% increase in EBIT for A and vice versa.
Price 5
Variable costs 3.5 High Operating Leverage is high risk.
Fixed Costs 15,000

Sales inc 10% Sales dec 10%

Sales 100000 110000 90000
- Variable Costs -70000 -77000 DOL -63000 DOL

- Fixed Costs -15000 -15000 -15000

EBIT 15000 18000 20% 12000 -20%
 Co A
If Co. A starts selling double the units, calculate the
Units produced 40,000 new DOL.
Price 5
Variable costs 3.5
Fixed Costs 15,000

DOL 40000 (5-3.5)

40000*1.5 – 15,000

We observe that DOL decreases as we produce more units.

DEGREE OF FINANCIAL LEVERAGE (DFL)

Measures the % change in Net Income (or EPS) to the % change in EBIT.

Financial Leverage is the use of fixed financing costs by the firm. Financial leverage is attained by choice. It
is used as a means of increasing the return to common shareholders (ROE).

It measures the sensitivity of Net Income or earnings per share (EPS) to the fluctuations in the EBIT.

Higher the DFL, higher the financial risk.

If the Co. has no debt, DFL will be 1 i.e. no financial risk.

 The operating income (EBIT) for A is:
Co A
20,000*(5 - 3.5) – 15000 = $15,000.
Units produced 20,000
Price 5 If this Co. had an annual interest expense of $10,000 calculate
Variable costs 3.5 the DFL.
Fixed Costs 15,000 If the EBIT increases by 10%, by how much will the Net income
(or EPS) increase?

SALES 100000
- VC -70000
- FC -15000
DFL = 15000 / (15000-10000)
EBIT 15000 16500
=3 - INTEREST -10000 -10000
NET INCOME 5000 6500 30%

Even if you take taxes into consideration, the net result of

30% is not affected.
DEGREE OF TOTAL LEVERAGE

It combines DOL and DFL. It measures the sensitivity of Net Income or EPS to change in Sales.
Calculate the DTL for both Cos. Given the following info:

Co A Co B
Units produced 20000 20000
Price $5 $5
Variable costs $3.5 $3
Fixed Costs $15,000 $30,000
Interest Cost $10,000 $6,000
DTL 6 10

Co. A
SALES 100000 110000 +10%
- VC -70000 -77000
- FC -15000 -15000
By how much will the EPS increase for both Cos, EBIT 15000 18000
if sales increase by 10%? - INTEREST -10000 -10000
NET INCOME 5000 8000 60%
BREAKEVEN QUANTITY

It refers to the no. of units or total sales required to cover all types of fixed costs. Net income here is zero.

Contribution Margin = (Price – Variable Cost) = what money is left after covering variable costs per unit of
sale. E.g. If 1 unit is sold for $10 out of which $6 is the variable costs, $4 remains which can be used to
cover the total fixed cost.

OPERATING BREAKEVEN QUANTITY OF SALES

Here we consider only fixed operating costs and ignore fixed finance costs (interest).
Find the BEQ and Operating BEQ for these Cos.

Co. A Co. B
Price 5 5
Variable Costs 2.5 3
Fixed operating costs 5000 6000
Fixed financing costs 3000 -

BEQ 5000 + 3000 6000

5-2.5 2
= 3200 units = 3000 units
Op BEQ 5000/2.5 6000/2
= 2000 units = 3000 units
 Co X Co Y
Units produced 12000 15000
Price 10 10
Variable costs 5 6
Fixed Costs $15,000 $30,000
Interest Cost $10,000 $6,000

Find DOL, DFL, DTL, BEQ and OP BEQ for these Cos

For Co X: For Co Y:
• Operating BEQ = $15,000 / $5 = 3,000 units • Operating BEQ = $30,000 / $4 = 7,500 units
• Total BEQ = ($15,000 + $10,000) / $5 = 5,000 units • Total BEQ = ($30,000 + $6,000) / $4 = 9,000 units
• DOL = $60,000 / $45,000 = 1.33x • DOL = $60,000 / $30,000 = 2.00x
• DFL = $45,000 / $35,000 = 1.29x • DFL = $30,000 / $24,000 = 1.25x
• DTL = 1.33 × 1.29 = 1.71x (or $60,000 / $35,000) • DTL = 2.00 × 1.25 = 2.50x (or $60,000 / $24,000)

Company X has less business/operating risk but more financial risk. X is operationally efficient. It is
using debt (financial leverage) to fund its operations, but because it keeps its fixed operating costs so low,
it remains a much less risky company overall compared to Company Y.