Leverages
PRESENTED BY
DHEERAJ

Definition of 'Leverage'
1. The use of various financial instruments or
borrowed capital, such as margin, to increase
the potential return of an investment.
2. The amount of debt used to finance a firm's
assets. A firm with significantly more debt than
equity is considered to be highly leveraged.

Classification
• There are two types of leverage:
– Operating leverage – fixed costs associated
with running the firm.
– Financial leverage – fixed costs associated
with financing the firm.
• Degree of leverage
– Measure of how much leverage the firm
uses.

Operating Leverage
• Operating leverage is the ratio of
a company's fixed costs to
its variable costs.
• A firm with relatively high fixed
operating costs will experience
more variable operating income if
sales change.

Effect of operating leverage
• More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales

Degree of Operating Leverage
(DOL)
• Operating leverage: by using fixed operating
costs, a small change in sales revenue is
magnified into a larger change in operating
income.
• This “multiplier effect” is called the degree of
operating leverage.

Degree of Operating Leverage
from Sales Level (S)
• DOLs = % change in EBIT
% change in sales
= change in EBIT
EBIT
change in sales
sales

Degree of Operating Leverage
from Sales Level (S)
DOLs = Sales - Variable Costs
EBIT
Q(P - V)
Q(P - V) - F
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.

What does this tell us?
• If DOL = 2, then a 1% increase in sales will
result in a 2% increase in operating income
(EBIT).
Stock-
Sales EBIT EPS holders

What does this tell us?
• If DOL = 2, then a 1% increase in sales will
result in a 2% increase in operating income
(EBIT).
Stock-
Sales EBIT EPS holders

Financial
Leverage
The use of fixed-cost sources of financing
(debt, preferred stock) rather than variable-
cost sources (common stock).

Degree of Financial Leverage
(DFL)
• Financial leverage: by using fixed cost
financing, a small change in operating
income is magnified into a larger change in
earnings per share.
• This “multiplier effect” is called the degree
of financial leverage.

Degree of Financial Leverage
DFL = % change in EPS
% change in EBIT
change in EPS
EPS
=
change in EBIT
EBIT

Degree of Financial Leverage
• If we have the data, we can use this formula:
DFL = EBIT
EBIT - I

What does this tell us?
• If DFL = 3, then a 1% increase in operating
income will result in a 3% increase in earnings
per share.
Stock-
Sales EBIT EPS holders

What does this tell us?
• If DFL = 3, then a 1% increase in operating
income will result in a 3% increase in earnings
per share.
Stock-
Sales EBIT EPS holders

Combined Leverage
• Combined leverage: by using operating leverage
and financial leverage, a small change in sales is
magnified into a larger change in earnings per
share.
• This “multiplier effect” is called the degree of
combined leverage.

Degree of Combined Leverage
DCL = DOL x DFL
% change in EPS
=
% change in Sales
change in EPS
EPS
=
change in Sales
Sales

Degree of Combined Leverage
• If we have the data, we can use this formula:
DCL = Sales - Variable Costs
EBIT - I
Q(P - V)
=
Q(P - V) - F - I

What does this tell us?
• If DCL = 4, then a 1% increase in sales
will result in a 4% increase in earnings
per share.
Stock-
Sales EBIT EPS holders

What does this tell us?
• If DCL = 4, then a 1% increase in sales
will result in a 4% increase in earnings
per share.
Stock-
Sales EBIT EPS holders

Levered Company
Sales (100,000 units) 1,400,000
Variable Costs 800,000
Fixed Costs 250,000
Interest paid 125,000
Tax rate 34%
Common shares outstanding 100,000

Degree of Operating Leverage from
Sales Level (S)
Sales - Variable Costs
DOLs =
EBIT
1,400,000 - 800,000
= 350,000
= 1.714

Degree of Financial Leverage
DFL = EBIT
EBIT - I
350,000
=
225,000
= 1.556

Degree of Combined Leverage
DCL = Sales - Variable Costs
EBIT - I
1,400,000 - 800,000
=
225,000
= 2.667