Chapter 9
For the Investor
Financial Leverage
The use of debt is referred to as financial
leverage
Interest as related to debt financing
A contractual obligation
Must be paid regardless of entity’s current
profits
Contrast with dividends which are discretionary
Interest is tax deductible
Reduces taxable income
Reduces income tax
Definition of Financial Leverage
and Magnification Effects
DOWELL COMPANY (Exhibit 9-1)
Financial Leverage
Partial Income Statement to Illustrate Magnification Effects
20% Decrease 10% Increase
in Earnings in Earnings
Base Year Before Interest Before Interest
Figures and Tax and Tax
Earnings before interest and tax $1,000,000 $ 800,000 $1,100,000
Interest (200,000) (200,000) (200,000)
Earnings before tax 800,000 600,000 900,000
Income tax (40%) (320,000) (240,000) (360,000)
Net income $ 480,000 $ 360,000 $ 540,000
Percentage change in net income [A] 25.0% 12.5%
Percentage change in earnings before
Interest and tax [B] 20.0% 10.0%
Degree of financial leverage [A ÷ B] 1.25 1.25
Net income increase [A] is greater than change in EBIT
[B] due to the fixed nature of interest expense
Computation of the Degree of
Financial Leverage
The degree of financial leverage is
% Change Net Income the multiplication factor by which
% Change EBIT the net income changes in respect
to changes in EBIT
Earnings Before
Interest and Tax A more simple formula for degree
Earnings Before Tax of financial leverage
Computation of the Degree of
Financial Leverage (cont’d)
Degree of financial leverage calculations
should exclude
Minority share of earnings
Equity income
Nonrecurring items
Earnings Before Interest, Tax,
Minority Share of Earnings, The all-inclusive
Equity Income, and Nonrecurring Items formula for degree of
Earnings Before Tax, financial leverage
Minority Share of Earnings,
Equity Income, and Nonrecurring Items
Earnings per Share
Required disclosure for corporate income
statements
Pertains only to common stock
Per-share amounts are disclosed for
Income from recurring items
Discontinued operations
Extraordinary items
Net income
Basic Earnings per Share
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
Earnings pertain to an entire fiscal period
Average common shares outstanding is used
Calculation of Weighted Average
Common Outstanding
Months Shares Shares Fraction of Year Weighted
Are Outstanding Outstanding × Outstanding = Average
January–June 10,000 × 6/12 = 5,000
July–September 12,000 × 3/12 = 3,000
October–December 15,000 × 3/12 = 3,750
11,750
Must take into account all stock dividends and
stock splits
Diluted Earnings Per Share
Complex capital structure contains potentially
dilutive securities:
Options, rights, warrants
Convertible debt
Convertible preferred equity
Net Income - Preferred
Dividends
Weighted Average # of Shares
Outstanding
+ All Above potential # of
Shares
Price/Earnings Ratio
Market Price per Share
Diluted Earnings per Share
Before Nonrecurring Items
Measures the relationship between the
market price of a share of common stock
and that stock’s current earnings per
share
Use of diluted earnings per share gives more
conservative price/earnings ratio
Price/Earnings Ratio (cont’d)
Compare with
Industry competitors
Industry average
Exchange (e.g., NYSE) average
Interpretation
High-growth-potential firms have higher P/E
ratios
P/E ratio can be a function of the market
Percentage of Earnings Retained
Net Income Before Nonrecurring
Items - All Dividends
Net Income Before
Nonrecurring Items
Reflects the proportion of current earnings
retained for internal growth
Trend analysis is improved by exclusion of
nonrecurring items
Higher percentage typically found in
New firms
Growing firms and firms perceived as growth firms
Dividend Payout
Dividends per Common Share
Diluted EPS Before Nonrecurring Items
Measures the portion of current earnings per
common share being paid out in dividends
A stable dividend policy is developed by
consideration of recurring earnings
Lower payout typically found in
New firms
Growing firms and firms perceived as growth firms
Dividend Yield
Dividends per Common Share
Market Price per Common Share
Indicates the relationship between the
dividends per common share and the
market price per common share
The yield is a function of
The firm’s dividend policy
Market price
Book Value per Share
Total Stockholders' Equity
- Preferred Stock Equity
Number of Common Shares Outstanding