Measures of Leverage

1. Measures of
Leverage

2. Section 1
An Introduction to Leverage
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3. An Illustration of
Unsystematic Risk
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4. What is Leverage?
 Leverage is usage of fixed costs
to increase company’s profitability;
 Fixed costs that are financial
costs creates financial leverage;
 Fixed costs that are operational
costs create operational leverage;
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5. The Effect of Leverage on
Company Earnings
 Leverage can magnify earnings both
up and down;
a. the profits of highly leveraged
companies by surge in case of even
small upturns in revenue;
a. on the contrary profits may suffer
from losses as a result of small
downturns in revenue;
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6. The Importance of
Leverage
 Company’s use of leverage needs attention for following
reasons;
a. it’s an integral part of risk-return assessments. High
level of increases the volatility of earnings and makes
company riskier for lenders and shareholders ;
b. valuation of company requires forecasting of future cash
flows and risk associated to this cash flows;
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7. Description of Leverage Effect
Example
Consider the following example of two companies which
have the identical performance;
Impulse Robotics Malvey
Aerospace
Revenue $1,000,000 $1,000,000
Operating Costs $700,000 $ 750,000
Operating Income $300,000 $ 350,000
Financing Cost $100,000 $150,000
Net Income $200,000 $200,000
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8. Description of Leverage Effect
Example
Now let’s examine the impact of cost structure on company
earnings!
Impulse Robotics Malvey
Aerospace
Number of units 100,000 100,000
Sales price per unit $10 $10
Variable cost per unit $2 $ 6
Fixed Operating Cost $500,000 $150,000
Fixed Financing Expense $100,000 $50,000
Obviously Impulse Robotics has a higher proportion of
fixed costs in it’s cost structure. So, it’s exposure to
sales risk will be greater
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9. Description of Leverage Effect
Example
Let’s restate the profit figure assuming that sales level is
50,000 units
Impulse Robotics Malvey Aerospace
Revenue $500,000 $500,000
Operating Costs $600,000 $450,000
Operating Loss/Income $100,000 $50,000
Financing Cost $100,000 $50,000
Net Loss $200,000 $0
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10. Description of Leverage Effect
Example
Let’s restate the profit figure assuming that sales level is now
200,000 units
Impulse Robotics Malvey Aerospace
Revenue $2000,000 $2000,000
Operating Costs $900,000 $1,350,000
Operating Income $1,100,000 $650,000
Financing Cost $100,000 $50,000
Net Income $1000,000 $600,000
The example clearly describes the degree of Impulse
Robotics’s sensitivity to sales level fluctuations. This fact is
compatible with high leverage figure.
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11. Section 2
Business Risk
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12. Business Risk and It’s
Components
 Business risk is typically related to company’s
operating earnings;
 Prices and quantity of sales are uncertain and
may be subject to deviations;
 This type of risk is referred as sales risk;
 Operating risk on the other hand roots from
company’s cost structure.Proportion of fixed costs
relative to variable costs is crucial in this respect;
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13. Operating Risk
 Risk deriving from the mix of fixed and variable costs is
referred as operating risk;
 The greater the portion of fixed to variable costs the
greater risk business will have;
 The high amount fixed costs on the other hand makes it
difficult for company to adjust it’s operating costs to their
sales level;
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14. Measuring of Operating
Leverage
 Response of operating earning to different
demand levels is gauged by DOL
(degree of operating leverage);
 In other words DOL is the measure
of operating leverage;
 DOL formula can be expressed as;
DOL=contribution margin
operating income
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15. Degree of Operating Leverage
Example
Global Auto divisions manufacture passenger cars and
produce the revenue of $93,000,000.It’s projected that
sales will increase by 10% due to increased demand in
cars.Global sold 6,000,000 passenger cars in 2009.The
average price per car was $24,000 and fixed costs
associated with car production is total of $15,000,000 per
year and variable costs per car are $14,000.Find the DOL
for Global Auto.
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Solution
DOL= 6000,000(24,000-14,000)______ = 1.33
6000,000(24000-14000)-15,000,000

16. Breakeven Analysis
 Short-term decision making tool;
 Sometimes referred as CVP(cost-volume-profit)analysis;
 Attempts to find activity level which turns profit to zero;
 Mathematically expressed as
Breakeven in units= Fixed Costs___
Price-Variable Cost
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17. Break-Even Calculation
Example
Let’s revisit Impulse Robotics and Malvey Aerospace
example;
Breakeven Impulse Robotics= 500,000+100,000=75,000 units
10-2
Breakeven Malvey Aerospace=150,000+50,000=50,000 units
10-6
The numbers tell that Impulse Robotics must sell 75,000 units in
order to earn zero net profit. Additionally it turns out that to be
profitable the company should sell more units in compared to
Malvey Aerospace(because it has higher operating leverage)
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18. Operating Breakeven
Point
 Breakeven point can also be specified in terms of
operating income;
 In this case fixed finance costs must be excluded;
Breakeven Impulse Robotics= 500,000=62,500 units
10-2
Breakeven Malvey Aerospace=150,000=37,500 units
10-6
The first figure means that if Impulse Robotics sells 62 500 units
of product it’s operating profit will be equal to zero.
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19. Limitations of Break-Even
Analysis
 Costs are classified either fixed or variables
costs however in the long run this distinction
is not valid;
 Assumes that changes in activity is the
only factor that affect cost;
 All units produced cannot be actually sold;
 Don’t take account sales price fluctuations;
 Is only applicable when only one type of product is sold or if there
multiple products that are sold in constant mix;
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20. Section 3
Financial Risk
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21. Definition of Financial
Risk
 Financial risk is the risk associated by how company
finances it’s operations;
 If debt is chosen as financing option then
company will be subject to financing risk;
 On the contrary if equity is the only
financing source for company then any
fixed obligation is unlikely to arise;
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22. Measuring of Financial
Leverage
 DFL(degree of financial leverage) looks the sensitivity of
cash flows available to owners when operating income
changes;
 Using more debt financing increases the volatility of net
income to changes in operating income;
 DFL formula can be presented as
DFL= Operating Income
Operating Income-Finance Cost
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23. Financial Leverage
Example
Let’s illustrate the effect of debt level on DFL
If operating income is $300,000 and fixed financing costs
are $100,000 the degree of financial leverage is
DFL= 300 000_______=1.5
300,000-100,000
Now consider that fixed financing cost is $150,000.
DFL=300 000_______=2
300,000-150,000
Based on the results it can be concluded that the greater usege of
debt as financing tool increases the sensitivity of net income to
changes in operating income
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24. The Leveraging Role of Debt
Example
Consider the Capital Company which is expected to
generate $1 500,000 in revenues and $500,000 in
operating earnings next year. Currently Capital Company
doesn’t use debt financing and has assets of $2000,000.
Suppose company were to change it’s capital structure
buying back $1000,000 of shares and issuing $1000,000 of
debt. If we assume that interest on debt is 5% and tax rate
is 30% what is the effect of debt financing on company’s
net income and ROE figure? Please note that operating
earning may deviate in an amount of 40percent.
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25. The Leveraging Role of Debt
Example
No Debt Expected Earnings Expected Earnings Expected Earnings
+40% -40%
EBIT $300,000 $500,000 $700,000
Taxes $90,000 $150,000 $210,000
Net Income $210,000 $350,000 $490,000
ROE 10.5% 17.5% 24.5%
New Expected Earnings Expected Earnings Expected Earnings
Structure +40% -40%
EBIT $300,000 $500,000 $700,000
Interest Expense $50,000 $50,000 $50,000
EBT $250,000 $450,000 $650,000
Taxes $75,000 $135,000 $195,000
Net Income $175,000 $315,000 $455,000
ROE 17.5% 31.5% 45.5% 25

26. Final Words on Financial
Leverage
 Unlike operating leverage degree of financial leverage is more
controllable by company management;
 Typically companies operating in the same industry have the similar
level of operating level, hence the similar cost structure;
 On the other hand companies with high ratios of tangible assets to
total assets are more inclined to have higher level of financial
leverage;
 One reason of this tendency is lenders feel more confident when
they supply fund for companies having more tangible assets;these
assets can be treated as collateral;
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27. Thank You