Leverage and Capital structure

Professor A. A. Azeez

Faculty of Graduate Studies

University of Colombo

9-1
 Leverage
• Leverage results from the use of fixed-cost
assets or funds to magnify returns to the firm’s
owners.
• Generally, increases in leverage result in
increased return and risk, whereas decreases in
leverage result in decreased return and risk.
• The amount of leverage in the firm’s capital
structure can significantly affect its value by
affecting return and risk.
• Because of its effect on value , the financial
manager must understand how to measure and
evaluate leverage.
9-2
 Types of Leverage
• Operating Leverage is concerned with the
relationship between the firm’s sales revenue
and its earnings before interest taxes (EBIT).
• Financial Leverage is concerned with the
relationship between the firm’s EBIT and its
common stock earnings per share (EPS).
• Total leverage is concerned with the
relationship between the firm’s sales revenue
and EPS.

9-3
 Operating Leverage

Operating Leverage -- The potential-use

of fixed operating costs to magnify the
effects of changes in sales on the
firm’s EBIT.

9-4
 Operating Leverage
• If the firm has fixed costs, it would have operating
leverage, and the percentage change in the operating
profit would be more for a given change in sales.

• A retail firm and an airline are typical examples

respectively of low and high operating leverage.

• Example, let us suppose that the firms A and B

manufacture the same product. Selling price is Rs. 8 per
unit of product and is equal for both firms. Fixed costs for
firms A and B respectively are Rs. 80,000 and Rs.
200,000 while variable costs per units are Rs. 6 and Rs.
4, respectively. What are the break-even points for the
firms? How much profits are earned by the firms if the
sale ranges betweeen 20,000 units to 80,000 units?

9-5
 Degree of Operating
Leverage (DOL)
Degree of Operating Leverage -- The
percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
DOL at Q units Percentage change in
of output
(or sales)
operating profit (EBIT)
=
Percentage change in
output (or sales)
9-6
 Computing the DOL
Calculating the DOL for a single product
or a single-product firm.

DOLQ units Q (P - V)
=
Q (P - V) - FC

= Q
Q - QBE
9-7
 Computing the DOL
Calculating the DOL for a
multiproduct firm.

DOLS Rupees of sales S - VC

=
S - VC - FC

EBIT + FC
=
EBIT
9-8
 The DOL: Example

Firm A wants to determine the degree of

operating leverage at sales levels of
50,000 and 80,000 units. As we did
earlier, we will assume that:
 Fixed costs are Rs.80,000
 Selling price is Rs. 8 each
 Variable costs are Rs. 6 per unit
9-9
 Computing Firm A’s DOL

Computation based on the calculated

break-even point of 40,000 units

DOL50,000 units
50,000 5
= =
50,000 - 40,000
80,000 2
DOL80,000 units = 80,000 - 40,000 =

9-10
 Interpretation of the DOL

A 1% increase in sales above the 80,000

unit level increases EBIT by 2% because
of the existing operating leverage of the
firm.

DOL80,000 units = 80,000 2

=
80,000 - 40,000
9-11
 Interpretation of the DOL

5
DEGREE OF OPERATING

4
3
LEVERAGE (DOL)

2
1
0
20,000 40,000 60,000 80,000
-1
-2
-3 QBE
-4
-5
QUANTITY PRODUCED AND SOLD
9-12
 Interpretation of the DOL

– DOL is a quantitative measure of the “sensitivity”

of a firm’s operating profit to a change in the
firm’s sales.
– The closer that a firm operates to its break-even
point, the higher is the absolute value of its DOL.
– When comparing firms, the firm with the highest
DOL is the firm that will be most “sensitive” to a
change in sales.

9-13
 DOL and Business Risk

Business Risk -- The inherent uncertainty

in the physical operations of the firm. Its
impact is shown in the variability of the
firm’s operating income (EBIT).
– DOL is only one component of business risk
and becomes “active” only in the presence of
sales and production cost variability.

– DOL magnifies the variability of operating profits

and, hence, business risk. 9-14
 Application of DOL for
Our Two Firm Example

Use the data in Slide 9-5 and the

following formula for Firm A:
DOL = [(EBIT + FC)/EBIT]

20,000 + 80,000
DOLRs.50,000 = = 5.0
20,000
sales
9-15
 Application of DOL for
Our Two Firm Example

Use the data in Slide 9-5 and the

following formula for Firm B:
DOL = [(EBIT + FC)/EBIT]

40,000 + 200,000
DOLRs.60,000 = = 6.0
40,000
sales
9-16
 Application of DOL for
Our Two-Firm Example
The ranked results indicate that the firm most
sensitive to the presence of operating leverage
is Firm B.
Firm A DOL = 5.0
Firm B DOL = 6.0
Firm B will expect a 300% increase in profit from a 50%
increase in sales.

9-17
 Financial Leverage
Financial Leverage -- The potential
use of fixed financial costs to
magnify the effects of changes in
EBIT on the firm’s EPS.
– Financial leverage is acquired by
choice.
– Used as a means of increasing the
return to common shareholders.
9-18
 EBIT-EPS Break-Even,
or Indifference, Analysis
EBIT-EPS Break-Even Analysis -- Analysis
of the effect of financing alternatives on
earnings per share. The break-even point is
the EBIT level where EPS is the same for
two (or more) alternatives.
Calculate EPS for a given level of EBIT at a
given financing structure.

(EBIT - I) (1 - t) - Pref. Div.

EPS =
# of Common Shares
9-19
 EBIT-EPS Chart

Firm A has Rs.2 million in LT financing (100%

common stock equity).

• Current common equity shares = 50,000

• Rs.1 million in new financing of either:
– All C.S. sold at Rs.20/share (50,000 shares)
– All debt with a coupon rate of 10%
– All P.S. with a dividend rate of 9%
• Expected EBIT = Rs.500,000
• Income tax rate is 30%
9-20
 EBIT-EPS Calculation with
New Equity Financing
Common Stock Equity Alternative
EBIT Rs.500,000 Rs.150,000*
Interest 0 0
EBT 500,000 150,000
Taxes (30% x EBT) 150,000 45,000
EAT 350,000 105,000
Preferred Dividends 0 0
EACS 350,000 105,000

# of Shares 100,000 100,000

EPS 3.50 1.05
* A second analysis using Rs.150,000 EBIT rather than the expected EBIT.
9-21
Earnings per Share (Rs.) EBIT-EPS Chart

4 Common
3

0
0 100 200 300 400 500 600 700

EBIT (Rs. thousands)

9-22
 EBIT-EPS Calculation with
New Debt Financing
Long-term Debt Alternative
EBIT Rs.500,000 Rs.150,000*
Interest 100,000 100,000
EBT 400,000 50,000
Taxes (30% x EBT) 120,000 15,000
EAT 280,000 35,000
Preferred Dividends 0 0
EACS 280,000 35,000

# of Shares 50,000 50,000

EPS 5.60 0.70
9-23
* A second analysis using 150,000 EBIT rather than the expected EBIT.
Earnings per Share (Rs.) EBIT-EPS Chart

6 Debt
5
Indifference point
between debt and
4
common stock
Common
3 financing

0
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
9-24
 EBIT-EPS Calculation with
New Preferred Financing
Preferred Stock Alternative
EBIT Rs.500,000 Rs.150,000*
Interest 0 0
EBT 500,000 150,000
Taxes (30% x EBT) 150,000 45,000
EAT 350,000 105,000
Preferred Dividends 90,000 90,000
EACS 260,000 15,000

# of Shares 50,000 50,000

EPS Rs.5.20 Rs.0.30
9-25
* A second analysis using Rs.150,000 EBIT rather than the expected EBIT.
Earnings per Share (Rs.) EBIT-EPS Chart

6 Debt Preferred
5

4 Common
3
Indifference point
2
between preferred
stock and common
1 stock financing

0
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
9-26
 What About Risk?
Debt
Earnings per Share (Rs.)

Probability of Occurrence
6

(for the probability distribution)

5 Lower risk. Only a small
probability that EPS will
4 be less if the debt
alternative is chosen. Common
3

0
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
9-27
 What About Risk?

Probability of Occurrence
Debt
Earnings per Share (Rs)

(for the probability distribution)

6

5 Higher risk. A much larger

probability that EPS will
4 be less if the debt
alternative is chosen.
3 Common

0
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
9-28
 Degree of Financial
Leverage (DFL)
Degree of Financial Leverage -- The
percentage change in a firm’s earnings
per share (EPS) resulting from a 1
percent change in operating profit.
DFL at EBIT Percentage change in
of X rupees
earnings per share (EPS)
=
Percentage change in
operating profit (EBIT)
9-29
 Computing the DFL
Calculating the DFL

DFL EBIT of Rs.X EBIT

=
EBIT - I - [ PD / (1 - t) ]

EBIT = Earnings before interest and taxes

I = Interest
PD = Preferred dividends
t = Corporate tax rate
9-30
 What is the DFL for Each
of the Financing Choices?
Calculating the DFL for NEW equity* alternative

DFL Rs.500,000 Rs.500,000

=
Rs.500,000 - 0 - [0 / (1 - 0)]

= 1.00

* The calculation is based on the expected EBIT

9-31
 What is the DFL for Each
of the Financing Choices?
Calculating the DFL for NEW debt * alternative

DFL Rs.500,000 Rs.500,000

=
{ Rs.500,000 - 100,000
- [0 / (1 - 0)] }
= Rs.500,000 / Rs.400,000

= 1.25
* The calculation is based on the expected EBIT
9-32
 What is the DFL for Each
of the Financing Choices?
Calculating the DFL for NEW preferred * alternative

DFL Rs.500,000 Rs.500,000

=
{ Rs.500,000 - 0
- [90,000 / (1 - .30)] }
= Rs.500,000 / Rs.371429

= 1.35
* The calculation is based on the expected EBIT 9-33
 Variability of EPS

DFLEquity = 1.00 Which financing

DFLDebt = 1.25 method will have
the greatest relative
DFLPreferred = 1.35 variability in EPS?

– Preferred stock financing will lead to the greatest

variability in earnings per share based on the
DFL.
– This is due to the tax deductibility of interest on
debt financing. 9-34
 Financial Risk

Financial Risk -- The added variability in

earnings per share (EPS) -- plus the risk of
possible insolvency -- that is induced by the
use of financial leverage.

– Debt increases the probability of cash insolvency

over an all-equity-financed firm. For example, our
example firm must have EBIT of at least
Rs.100,000 to cover the interest payment.
– Debt also increased the variability in EPS as the
9-35
DFL increased from 1.00 to 1.25.
 Total Leverage
Total Leverage -- The potential use
of fixed costs, both operating and
financial, to magnify the effects of
changes in sales on the firm’s
EPS.

– Total leverage can therefore be viewed as

the total impact of the fixed costs in the firm’s
operating and financial structure.
9-36
 Degree of Total
Leverage (DTL)
Degree of Total Leverage -- The
percentage change in a firm’s earnings
per share (EPS) resulting from a 1
percent change in output (sales).
DTL at Q units (or S Percentage change in
rupees) of output (or
sales)
earnings per share (EPS)
=
Percentage change in
output (or sales)
9-37
 Computing the DTL

DTLS rupees = (DOL S rupees) x (DFLEBIT of Rs.S )

EBIT + FC
DTL S rupees =
of sales EBIT - I - [ PD / (1 - t) ]

9-38
 DTL Example

Firm A wants to determine the Degree

of Total Leverage at EBIT=Rs.500,000.
As we did earlier, we will assume that:
 Fixed costs are Rs.80,000
 Selling price is Rs. 8 each
 Variable costs are Rs.6 per unit

9-39
 Computing the DTL
for All-Equity Financing
DTLS rupees = (DOL S rupees) x (DFLEBIT of Rs.S )
DTLS rupees = (1.16 ) x ( 1.0* ) = 1.16

DTL S rupees Rs.500,000 + Rs.80,000

of sales
=
Rs.500,000 - 0 - [ 0 / (1 - .3) ]

= 1.16
*Note: No financial leverage.
9-40
 Computing the DTL
for Debt Financing
DTLS rupees = (DOL S rupees) x (DFLEBIT of Rs.S )
DTLS rupees = (1.16 ) x ( 1.25* ) = 1.45

DTL S rupees Rs.500,000 + Rs.80,000

=
of sales
{ Rs.500,000 – Rs.100,000
- [ 0 / (1 - .3) ] }
= 1.45
9-41
 Risk versus Return

Compare the expected EPS to the DTL for

the common stock equity financing
approach to the debt financing approach.
Financing E(EPS) DTL
Equity Rs.3.50 1.16
Debt Rs.5.60 1.45
Greater expected return (higher EPS) comes at
the expense of greater potential risk (higher DTL)!
9-42
 Capital Structure

Capital Structure -- The mix (or proportion) of a

firm’s permanent long-term financing represented
by debt, preferred stock, and common stock
equity.

9-43
 Capital Structure and the Pie

• The value of a firm is defined to be the sum of

the value of the firm’s debt and the firm’s equity.
V=B+S

• If the goal of the firm’s

management is to make the S B
firm as valuable as possible,
then the firm should pick the
debt-equity ratio that makes
the pie as big as possible.
Value of the Firm
9-44
 Capital Restructuring
• We are going to look at how changes in capital
structure affect the value of the firm, all else equal
• Capital restructuring involves changing the amount of
leverage a firm has without changing the firm’s assets
• The firm can increase leverage by issuing debt and
repurchasing outstanding shares
• The firm can decrease leverage by issuing new shares
and retiring outstanding debt

9-4516-45
Choosing a Capital Structure
• What is the primary goal of financial managers?
– Maximize stockholder wealth
• We want to choose the capital structure that will
maximize stockholder wealth
• We can maximize stockholder wealth by
maximizing the value of the firm or minimizing
the WACC

9-4616-46
 The Effect of Leverage
• How does leverage affect the EPS and ROE of a firm?
• When we increase the amount of debt financing, we
increase the fixed interest expense
• If we have a really good year, then we pay our fixed cost
and we have more left over for our stockholders
• If we have a really bad year, we still have to pay our fixed
costs and we have less left over for our stockholders
• Leverage amplifies the variation in both EPS and ROE

9-4716-47
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is contemplating going into
debt.

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50
9-48
 EPS and ROE Under Current
Structure
Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0
Net incomeRs.1,000 Rs.2,000 Rs.3,000
EPS Rs.2.50 Rs.5.00 Rs.7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
9-49
EPS and ROE Under Proposed
Structure
Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 640 640 640
Net income Rs.360 Rs.1,360 Rs.2,360
EPS Rs.1.50 Rs.5.67 Rs.9.83
ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
9-50
Financial Leverage and EPS
12.00

10.00 Debt

8.00 No Debt

6.00 Break-even Advantage

EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in rupees, no taxes
to debt
9-51