A presentation on "Leverage" Types of Leverage, Types of Risk, DOL, DFL.

2. Shariat Rabby Sadat
B3160B012

3. What is Leverage in Finance?
Leverage is the investment strategy of using borrowed money:
specifically, the use of various financial instruments or borrowed
capital to increase the potential return of an investment.
Leverage can also refer to the amount of debt used to finance.
It is used to calculate Debt-Equity Ratio.
Debt-Equity Ratio =
Total Debt
Total Asset

4. Types of Fixed Cost
Fixed Cost
Operational
Fixed Cost
Financial
Fixed Cost

5. Types of Risk
Risk
Operational
Risk
Financial
Risk
Unable to bear both risk is called total risk

6. Types of Leverage
Leverage
Degree of Operating Leverage
(DOL)
Degree of Financial Leverage
(DFL)
Degree of Combined
Leverage
(DCL)

7. Degree of Operating Leverage
• Definition: It is a relationship between a companies fixed and variable
cost which summarizes the effect of a particular amount of operating
leverage on a company’s EBIT.
Formula: DOL=
[Where EBIT means earning before interest and taxes]

8. Implementation of DOL
• Problem: Assume Company X has $500,000 in sales in year
one and $600,000 in sales in year two. For year one, the
company's operating expenses were $150,000, while in year
two, the operating expenses were $175,000.

9. Implementation of DOL (cont’d)
• Solution: Year one EBIT = $500,000 - $150,000 = $350,000
Year two EBIT = $600,000 - $175,000 = $425,000
• % change in EBIT = $425,000 / $350,000 - 1 = 21.43%
• % change in sales = $600,000 / $500,000 -1 = 20%
DOL=21.43% / 20% = 107.14%
[If the DOL of a company is high, this means a relatively small
increase in sales can have a large effect on net operating income]

10. Degree of Financial Leverage
• Definition: It measures the sensitivity of a company’s operating
income due to changes in its capital structure. DFL is used to help a
company determine an appropriate amount of Debt.
• Formula: DFL =
[Where EPS means earning per share]

11. Implementation of DFL
• Problem: ABC Company earned $500,000 in Year 1. It had no debt, so
its EBIT and EBIT – Interest are the same. The DFL ratio is 1. Now
assume ABC is considering expanding its manufacturing facility, at a
cost of $1 million. If ABC borrows the money, it will incur $60,000 in
interest expenses. Assume it is estimated that ABC’s revenue for Year
2 will increase to $600,000 as a result of the expanded business.
• Solution: Year 2 DFL = $600,000/($600,000 - $60,000) = 1.11
[This means that for every change in earnings before taxes, there is a 1.11x change
in EBIT. So management’s decision to borrow the money paid off, because the
increase in revenue more than covered the debt incurred to fund the expansion]

12. Degree of Combined Leverage
• Definition: It summarizes the combined effect that DOL and DFL have
on EPS, given a particular change in sales. It helps to determine the
most optimum level of financial and operating leverage to use in a
FIRM.
• Formula: DCL =

13. Implementation of DCL
• Problem: A firm selling price of its product is $100 per unit.
The variable cost per unit is $50 and the fixed operating costs
are $50,000 per year. The fixed interest expenses (non-
operating) are $25,000 and the firm has 10,000 shares
outstanding. Let us evaluate the combined leverage resulting
from sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.

14. Implementation of DCL (cont’d)

15. Implementation of DCL (cont’d)
• Solution:
• Percentage Change in EPS= ($4.875 - $1.625)/ $1.625 * 100 = 200%
• Percentage change in Sales= ($300,000 - $200,000)/ $200,000 * 100 = 50%
• DCL= 200% / 50% = 4
[A combined leverage (total risk) of 4 indicates that for every $1 change in sales,
there would be a $4 change in the Earnings per share in either direction]

16. “ধন্যবাদ“