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Financial leverage
The document defines leverage as using fixed costs to magnify returns. There are two types of fixed costs: operating costs like rent and salaries, and financial costs like interest from debt. Leverage can increase risk but also returns. There are three types of leverage: operating, financial, and total. Operating leverage is the effect of fixed operating costs on income. Financial leverage is the effect of fixed financing costs like debt and preferred stock on earnings per share. Degree of operating leverage and degree of financial leverage measure the multiplier effect of each type of leverage. Examples using data from a levered company show that a 10% increase in sales would increase operating income by 17.14% due to operating leverage of 1.714, and operating income
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Financial leverage
- 1. Submitted By: Samarth Gupta 18MBAIB14 FinancialManagement PSMBAIBTC0204 International Centre for Cross Cultural Research & Human Resource Management
- 3. What is Leverage? In general terms, leverage means the use of force and effects to produce a more than normal results from a given action In other words, leverage is the advantage generated by using a lever Example, using a jack to lift a car In Finance, leverage is the use of fixed costs to magnify the potential return to a firm 2 types of fixed costs: fixed operating costs = rent, salaries, etc. fixed financial costs = interest costs from debt
- 4. What is Leverage? Leverage can magnify returns to common stockholders but can also increase risk Management has almost complete control over this risk introduced through the use of leverage (fixed costs) The degree in the use of leverage depends on management’s attitude toward risk and the nature of its business, among others. Three types of leverage with reference to the firm’s income statement: Operating leverage, Financial leverage, and Combined (Total) leverage. Leverage is measured on the profitability range of operations.
- 5. What is Leverage? Sales Less:Total variable Costs Contribution Margin Less: Fixed Cost Earnings Before Interest and Taxes (EBIT) Less: Interest Earnings Before Taxes Less: Taxes Earnings After Taxes (EAT) Number of Shares Outstanding Earnings Per Share Operating leverage Financial leverage
- 6. Operating Leverage Theuse of fixed operating costs as opposed to variable operating costs. A firm with relatively high fixed operating costs will experience more variable operating income if sales change.
- 7. 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.
- 8. DOLs = %change in EBIT % change in sales change in EBIT EBIT change in sales sales = Degree of Operating Leverage from Sales Level (S)
- 9. If wehave the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT
- 10. Financial Leverage The useof fixed-cost sources of financing (debt, preferred stock) rather than variable- cost sources (common stock).
- 11. Financial Risk Thevariability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRMEBIT EPS Stock- holders
- 12. 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.
- 13. DFL = %change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT Degree of Financial Leverage =
- 14. Degree of Financial Leverage If we have the data, we can use this formula: DFL = EBIT EBIT - I
- 15. What does thistell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holdersEBIT EPSSales
- 16. Based on thefollowing information on Levered Company, let us try to answer these questions: 1) If sales increase by 10%, what should happen to operating income? 2) If operating income increases by 10%, what should happen to EPS?
- 17. Levered Company Sales (100,000units) $1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Common shares outstanding 100,000
- 18.
- 19. Degree of Operating Leveragefrom Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT
- 20.
- 21. Degree of Financial Leverage DFL= EBIT EBIT - I = 350,000 225,000 = 1.556
- 22.
- 23. Sales (110,000 units)1,540,000 Variable Costs (880,000) Fixed Costs (250,000) EBIT 410,000 ( +17.14%) Interest (125,000) EBT 285,000 (+26.67%) Taxes (34%) (96,900) Net Income 188,100 EPS $1.881 ( +26.67%) Levered Company 10% increase in sales