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

1. Submitted By:
Samarth Gupta
18MBAIB14
Financial Management
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
 The use 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 we have the data, we can use this formula:
Degree of Operating Leverage
from Sales Level (S)
DOLs =
Sales - Variable Costs
EBIT

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

11. Financial Risk
 The variability 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 this tell 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 the following 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 (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Common shares outstanding 100,000

18. EPS
Financial
leverage
Operating
Income
Sales
Operating
leverage
Levered Company

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

20. EPS
Operating
Income
Sales
Operating
leverage
10%
17.14%
Levered Company

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

22. EPS
Financial
leverage
Operating
Income
Sales
10%
15.56%
Levered
Company

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