Measures of leverage Flashcards
Leverage is what and it has two components
- leverage is the use of fixed costs in a firm’s cost structure
- operating leverage: fixed op costs; depreciation, rent, etc
- financial leverage: fixed financial costs; interest expense, debt
A higher degree of leverage means what to a firm?
- leverage increases volatility of a firm’s earnings and CF
- leverage increases the risk of lending to or owning the firm
the higher a firm’s leverage, the higher the risk
- which will require a higher discount rate to be applied in valuation
high leverage = high risk = high discount rate
Business risk is what and its components are what
- business risk is associated with operating earnings
components
- sales risk
- operating risk
Operating risk is the risk due to operating cost structure
- it is greater when fixed operating costs are higher relative to variable operating costs
Degree of operating leverage (DOL)
definition and formula
- DOL measures how sensitive a firm’s operating income is to changes in sales
- a DOL of 2 means that for a 1% change in units sold results in a 2% change in operating income
DOL = % change in operating income / % change in units sold
DOL = Q(P-V) / Q(P-V) - F
F = fixed operating cost
P-V = per unit contribution margin
Q(P-V) = contribution margin
*ignore fixed financing costs
Compute DOL number of units sold 100 sales price per unit 1 variable cost per unit 0.2 fixed operating cost 50 fixed financing cost 10
DOL = Q(P-V) / Q(P-V) - F
100 - (1 - 0.2) / 100 - (1 - 0.2) - 50
DOL = 2.67
*ignore fixed financing cost
Financial risk and DF
financial risk depends on how a firm finances its operations with D and/or E
the greater use of debt, the greater is the company’s financial risk
DFL measures financial risk. A DFL of 2 means, a 1% increase in operating income will result in a 2% increase in NET INCOME
DFL = % change in NI / % change in operating income DFL = operating income / operating income - intrest expense DFL = EBIT / EBT DFL = Q*(P-V) - F / Q*(P-V) - F - C F= fixed operating costs C= fixed financial costs
Compute DFL number of units sold 100 sales price per unit 1 variable cost per unit 0.2 fixed operating cost 50 fixed financing cost 10
DFL = Q(P-V) - F / Q(P-V) - F - C
100(1-0.2) - 50 / 100(1-0.2) - 50 - 10
= 1.5
Effects of financial leverage on ROE
- higher financial leverage leads to higher ROE volatility and potentially higher ROE levels
ROE = NI / equity
all else equal, a lower equity value has a positive effect on ROE
Total leverage and degree of total leverage (DTL)
- total leverage: the combined effect of operating leverage and financial leverage
- DTL measures the sensitivity of net income to changes in the number of units produced and sold
DTL formulas
DTL = % change in NI / % change in units sold
DTL = DOL * DFL
DTL = Q(P-V) / Q(P-V) - F - C
*no -F in numerator
Compute DTL number of units sold 100 sales price per unit 1 variable cost per unit 0.2 fixed operating cost 50 fixed financing cost 10
DTL = Q(P-V) / Q(P-V) - F - F
100 * 0.8 / 100 * 0.8 - 50 - 10
DTL = 4
Breakeven point and operating breakeven point
BEP: is the number of units produced and sold at which net income is zero,
- the point at which revenues are equal to costs
OBEP: is the number of units produced and sold at which operating income is zero
all else equal, companies that have high operating and financial leverage will have high BEP as compared to firms with low leverage
BEP equation
BEP
QBE = F + C / P - V
quantity BE = fixed op costs + fixed fin costs / price per unit - variable cost per unit
OBEP equation
QOBE = F / P - V
Find BEP and OBEP number of units sold 100 sales price per unit 1 variable cost per unit 0.2 fixed operating cost 50 fixed financing cost 10
QBE = F + C / P - V QOBE = F / P - V
BE=
50 + 10 / 1 - .2
=75
OBE =
50 / 1 - .2
= 62.4
