A Report On Effect of leverage on EPS and EBIT:

British American Tobacco

Group Profile

SL Name ID

1 Md Zarif Ibne Arif 19-093

2 Sadia Salsabila Jerin 19-095

3 Syed Shadab Mahbub 19-097

4 Md.Monjurul Ahsan 19-099

5 Shohel Hossain 19-101

Letter Of Transmittal

November 20,2016

Dr. Md. Kismatul Ahsan

Professor

Department Of Finance

University of Dhaka

Subject: Submission of report on the Effect of leverage on EPS and EBIT of British American

Tobacco Bangladesh

Dear Sir,

It is a great pleasure for us to submit the report on “Effect of leverage on EPS and EBIT of British

American Tobacco Bangladesh” as per our requirement for course F-406; Corporate Finance. Writing this

report has been a challenging but interesting experience for us.

After completing this report, we can say that we have learnt about the practical implications of Effect of

leverage and has given us the scope of applying theoretical knowledge in the case of real companies.

We have undertaken our sincerest effort for successful completion of this report and we hope that any

unintentional error, omission or mistake committed by us while preparing this report will be considered

with sympathy. Therefore, we beg your kind consideration in this regard. We will be very grateful if you

accept our report and oblige thereby.

Sincerely,

Syed Shadab Mahbub

ID-19-097

On behalf of group no. B.B.A. 19th

Batch Department of Finance, University of Dhaka

Acknowledgement

First of all we would like to express our gratitude from heart to the Beneficent, the Merciful, & Almighty

Allah for giving us the strength and patience to prepare this report within the scheduled time.

This is a great opportunity for us to make a report on such topic. We express our thanks to our dear course

teacher Dr. Md. Kismatul Ahsan for assigning us a report about Effect of leverage on EPS & EBIT of

British American Tobacco. In this regard, we would also like to thank ourselves for our good team work

and successful team spirit. Without co-operation and the support from each other, it would not be possible

to prepare this report.

We hope the report will help us pursuing our goal in the near future. We also hope we will be able to

implement the knowledge that we have acquired from this report in real life. So lastly, we would again

like to express our heartfelt thanks to our course teacher for giving his valuable suggestions and precious

contributions.

Executive Summary

The purpose of this report is to gain an holistic understanding of the effect of leverage on EPS and EBIT

of British American Tobacco as a company. We began the report with a company analysis, where we

tried to present the real life scenario about the strengths and weakness of the company and its implications

on our valuation. Furthermore, we tried to adjust the financial statements to show the effect of leverage on

EPS and EBIT of the company.

In order gain a view of the broader picture, we also conducted breakeven analysis, which formed a very

important basis of the assumptions that we had to make in order to project future financial performance of

the business, and also gave us a sense of how much units to produce to avoid losses given the economy’s

demographic structure.

Based on certain assumptions, projections were made both for local sales and exports, and it was the basis

of forming the scenario analysis and graphs. We applied the degree of operating leverage, degree of

financial leverage, breakeven analysis of the company from different angles to gain an in-dept

understanding of cost and capital structure of BATBC.

Table Of Content

Sl name Pg

1 Chapter 01: Introduction 01

2 Chapter 02: Theoritical background 03

3 Chapter 03: Application to theory 19

4 Conclusion 24

About the British American Tobacco

British American Tobacco Bangladesh was born in 1910 as Imperial Tobacco Company and was one of

the first multinational companies in Bangladesh. As the nation advanced through adversity and political

turmoil, the company too withstood its own challenges. As Bangladesh progressed, so did the Company,

with a global identity as British American Tobacco (BAT) Bangladesh transformed in 1998. Over the

years, BAT Bangladesh has proven itself to be an organisation capable of excellence – through its people,

its products and business practices.

Employing more than 1,350 people directly and approximately 52,000 people indirectly as farmers,

distributors and local suppliers, BAT is also one of the most widely recognized brands in the country and

also one of the largest tax payers.

Sourcing, Production, Distribution & Consumers BAT has significantly invested to capture value in the entirety of the value chain in the tobacco industry

to provide seamless sourcing, innovation at the production level, nationwide distribution and direct

branding opportunities with its customers. BAT sources leafs and other materials via its partnerships with

farmers and also houses state of the art manufacturing facilities to support a scalable operational

infrastructure.

Continued sales growth has been made possible due to the strength of BAT’s distribution channel, and the

relationships it nurtures with wholesalers, retailers and logistic providers.

Products Key product offerings include a variety of tobacco products with numerous scopes of product and pricing

differentiation. The following are the brands for BAT:

● Benson & Hedges

● John Player

● Gold Leaf

● Pall Mall

● Capstan

● Star

● Derby

● Hollywood

Apart from its own brands, BAT’s main product - tobacco leaf is also exported to its sister concerns in

countries like China and India. However, the latest imposition of 10% leaf exporting tax, has been a cause

for concern, and our valuation has incorporated the consequential price shock, which we predict that

Bangladesh’s cost-effectiveness will restore BAT’s competitiveness in the global market.

As mentioned before, BAT is revenue driven organization, where the majority of its sales comes from the

sale of the brands mentioned above. While sales have enjoyed consistent growth in the latest financial

periods, some factors that we have to take into consideration would be increasing competition, and

government policies to increase VAT charges which is ultimately going to have an inflationary effect on

the prices of cigarettes.

01

Chapter 01: Introduction

That being, on the other hand the Bangladeshi economy is reaping its demographic dividend, with

tobacco consumers steadily growing over the last decade. As population, and more significantly, its

structure continues to evolve, more and more people are speculated to begin consuming tobacco products.

To address the diverse needs of the consumer base, BAT’s array of brands are structured, as per law into

certain segments in accordance to their prices:

Premium Benson and Hedges

High John Player Gold Leaf, Pall Mall, Capstan

Medium Star

Low Derby Hollywood

These segments are an industry and this segmentation is imposed on the basis of their pricing. In the

premium segment, BAT enjoys market leadership, although it constitutes for a relatively smaller part of

the overall tobacco market. Growth is predicted to be be stagnant, though it is predicted to become more

competitive in the high and medium segment in the upcoming years due to competitors launching their

own brands.

BAT’s main competition includes Phillip Morris International, Dhaka Tobacco & Akij Biri. BAT has

been known to service the upper segment of the market and has been more aggressive in terms of

marketing and distribution for that target market as opposed to the lower segment where local players

boasts coast leadership.

Cost structure for a company like BAT is stable, and apart from investing and maintaining its equipment,

we cannot forecast any other significant capitation expenditure. In terms of operation efficiency, we can

also predict a stable cost structure, and within the scope of our study, we could not identify any

operational bottlenecks which could hamper future growth.

However, a factor that is outside company control are the Supplementary duty and the VAT charges that

will be imposed by the government. In fact, as per the comments of our Finance Minister, there have been

significant pressure by anti-tobacco lobbyists for the government to place more pressure to discourage

tobacco sales. Upward pressure on Supplementary duty has also been accounted for in the course of our

valuation.

02

Fixed cost

A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or

services produced or sold. Fixed costs are expenses that have to be paid by a company,

independent of any business activity. It is one of the two components of the total cost of running

a business, along with variable cost.

Figure 1: fixed cost

A fixed cost is an operating expense of a business that cannot be avoided regardless of the level

of production. Fixed costs are usually used in breakeven analysis to determine pricing and the

level of production and sales under which a company generates neither profit nor loss. Fixed

costs and variable costs form the total cost structure of a company, which plays a crucial role in

ensuring its profitability.

Variable Cost

A variable cost is a corporate expense that varies with production output. Variable costs are those

costs that vary depending on a company's production volume; they rise as production increases

and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising,

insurance and office supplies, which tend to remain the same regardless of production output.

Fixed costs and variable costs comprise total cost.

2

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Chapter 02: Theoritical background.

Variable costs can include direct material costs or direct labor costs necessary to complete a

certain project. For example, a company may have variable costs associated with the packaging

of one of its products. As the company moves more of this product, the costs for packaging will

increase. Conversely, when fewer of these products are sold the costs for packaging will

consequently decrease.

Figure 3: Total cost

Discretionary fixed cost

A discretionary fixed cost is an expenditure for a period-specific cost or a fixed asset, which can

be eliminated or reduced without having an immediate impact on the reported profitability of a

business. There are not many discretionary fixed costs, but they can be quite large, and so are

worth considerable review by management.

The following can be considered discretionary fixed costs:

Advertising campaigns

Employee training

Investor relations

Public relations

Research and development activities for specific products

Committed fixed cost

Committed fixed costs are those fixed costs that are difficult to adjust and that relate to the

investment in facilities, equipment, and the basic organizational structure of a firm. A committed

fixed cost has a long future planning horizon— more than on year. These types of costs relate to

a company’s investment in assets such as facilities and equipment. Once such costs have been

incurred, the company is required to make future payments.

Why Are Committed Fixed Costs the Most Difficult to Change

The following reasons are the main hindrance for not to change committed fixed cost-

Long-TermThe long-term nature of committed costs makes them difficult to change. A small consulting business cannot break its long-term office lease without paying significant penalties.

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Similarly, companies cannot break labor wage agreements or refuse to honor management contracts. A manufacturing company that owns its facilities must pay property taxes and spend certain amounts annually for maintenance work.

OperationsOperational reasons make it difficult to change committed costs. Restaurants and retail stores cannot change locations easily because they might lose their regular customers. In addition, they would have to allocate additional resources to developing a client base in their new locations. Depreciation is another committed operating expense that is difficult to change. It is the phased allocation of a fixed asset's cost over its useful life. Fixed assets are physical assets with useful lives substantially longer than a year, such as computers and buildings. However, depreciation is a noncash expense that affects net income but not cash flow.

Strategy

Committed costs usually are an extension of corporate strategy. Businesses spend time and resources thinking through and implementing strategic options. Major decisions, such as building a manufacturing facility or expanding into a new geographic market, usually are part of long-term plans to drive revenue growth and diversify. Companies cannot walk away from strategic research and development initiatives to bring new products to market. Similarly, companies cannot change marketing plans designed to support the launch of new products and achieve market share growth.

Considerations

Start-up companies usually have fewer committed costs because management may want to retain as much operational flexibility as possible. A consulting business can start out as a home-based business and wait to sign a long-term office lease until it has secured a few clients. Similarly, a manufacturer looking to expand into a new market should not start out by building stores and distribution centers. Instead, it should first explore distribution arrangements with local businesses because these are easier to change.

Operating Leverage

Operating leverage is a measurement of the degree to which a firm or project incurs a

combination of fixed and variable costs. A business that makes sales providing a very high gross

margin and fewer fixed costs and variable costs has much leverage. The higher the degree of

operating leverage, the greater the potential danger from forecasting risk, where a relatively

small error in forecasting sales can be magnified into large errors in cash flow projections.

High and Low Operating Leverage

It is essential to compare operating leverage among companies in the same industry, as some

industries have higher fixed costs than others. The concept of a high or low ratio is then more

clearly determined.

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Most of a company’s costs are fixed costs that occur regardless of sales volume. As long as a

business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs

are covered and profits are earned. Other company costs are variable costs incurred when sales

occur. The business earns less profit on each sale but needs a lower sales volume for covering

fixed costs. However, the business does not generate greater profits unless it increases its sales

volume.

For example, a software business has greater fixed costs in developers’ salaries, and lower

variable costs with software sales. Therefore, the business has high operating leverage. In

contrast, a computer consulting firm charges its clients hourly, resulting in variable consultant

wages. Therefore, the business has low operating leverage.

Figure 4: Effect of high & low OL on EBIT

Degree Of Operating Leverage - DOL

The degree of operating leverage (DOL) is a leverage ratio that summarizes the effect a

particular amount of operating leverage has on a company's earnings before interest and taxes

(EBIT) over a period of time. Operating leverage involves using a large proportion of fixed costs

to variable costs in the operations of the company. The formula is as follows:

Degree of Operating Leverage Formula

The formula for the DOL takes into account two variables. They are:

1) The percentage change in EBIT from time period one to time period two

2) The percentage change in sales from time period one to time period two

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The formula is then, DOL = % change in EBIT / % change in sales

EBIT can be calculated by taking the sales revenue and subtracting the operating expenses.

The Degree of Operating Leverage Ratio helps a company in understanding the effects of

operating leverage on the company’s probable earnings. It is also important in determining a

suitable level of operating leverage which can be used in order to get the most out of the

company’s Earnings before interest and taxes or EBIT.

If the operating leverage is high, then a smallest percentage change in sales can increase the net

operating income. The net operating income is the amount of income that is left after payments

of fixed cost are made, regardless of how much sales has been made. Since the Degree of

Operating Leverage or DOL helps in determining how the change in sales volume would affect

the profits of the company, it is important to ascertain the value of degree of operating leverage

in order to minimize the losses to the company.

A business would benefit if the can estimate the Degree of Operating Leverage or DOL. The

impact of the leverage on the percentage of sales can be quite striking if not taken seriously;

therefore it is really important to minimize these risks of the business. If you get a higher degree

of operating leverage or DOL then you should try and balance the operating leverage to balance

with the financial leverage in order to provide with profits to the company. A company’s balance

Degree of Operating Leverage can provide the financial leverage is an important factor

contributing to business profits. Even a small percentage of increase in sales can help in having a

greater proportion of profits in the company, so it is really important to maintain a balance

between both financial leverage and operating leverage to yield maximum benefits.

Financial Leverage

Financial leverage is the degree to which a company uses fixed-income securities such as debt

and preferred equity. The more debt financing a company uses, the higher its financial leverage.

A high degree of financial leverage means high interest payments, which negatively affect the

company's bottom-line earnings per share.

Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred

equities in a company's capital structure. As a company increases debt and preferred equities,

interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A

company should keep its optimal capital structure in mind when making financing decisions to

ensure any increases in debt and preferred equity increase the value of the company.

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Degree of Financial Leverage

The formula for calculating a company's degree of financial leverage (DFL) measures the

percentage change in earnings per share over the percentage change in EBIT. DFL is the measure

of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

Formula:

Or

The degree of financial leverage or DFL helps in calculating the comparative change in net

income caused by a change in the capital structure of business. This ratio would help in

determining the fate of net income of the business. This ratio also helps in determining the

suitable financial leverage which is to be used to achieve the business goal. The higher the

leverage of the company, the more risk it has, and a business should try and balance it as

leverage is similar to having a debt.

This formula can be even used to compare data of many companies that can help an investor in

deciding which company to invest in, based on the result of how much risk is attached with each

companies capital structures. It would help an investor to strike a great deal as when the there is

an economic decline the losses of the company can be substantiated with this investment and

during the rise in the economic conditions the volume of sales would be well compensated.

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The degree of financial leverage is useful for figuring out the fate of net income in the future,

which is based on the changes that take place in the interest rates, taxes, operating expenses and

other financial factors. Debts added to a business would provide an interest expense to the

company which is a fixed cost, and this is when the company’s business begins to turn to provide

profit. It is important to balance the financial leverage according to the operating costs of the

company as it would minimize the level of risks involved.

Degree of Total Leverage (DTL)

By combining the degree of operating leverage with the degree of financial leverage we obtain

the degree of total leverage (DTL). If a firm has a high amount of operating leverage and

financial leverage, a small change in sales will lead to a large variability in EPS. The degree of

total leverage can calculate by the following formula-

The first way to figure the DTL is by multiplying the DOL by the DFL. The DOL equals the

company's percentage change in earnings before interest and taxes divided by the company's

percentage change in sales, while the DFL equals the percentage change in earnings per share

divided by the percentage change in EBIT.

For example, Newco produces 140,000 units annually. The company's variable costs are $20 per

unit, price per unit is $50 and its fixed costs total $2.4 million. The company's annual interest

expense amounts to $100,000 annually. If Newco's sales increase by 20%, what is the impact to

the company's EPS?

Answer: DTL = 140,000(50-20)/140,000(50-20)-2,400,000 - $100,000 = 2.47

If Newco's sales increase by 20%, the company's EPS will increase by 49.4% (20%)(2.47).

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Break-even Point

The break-even point (BEP) in economics, business, and specifically cost accounting, is the

point at which total cost and total revenue are equal: there is no net loss or gain, and one has

"broken even." A profit or a loss has not been made, although opportunity costs have been

"paid", and capital has received the risk-adjusted, expected return. In short, all costs that needs to

be paid are paid by the firm but the profit is equal to 0.

In accounting, the break-even point refers to the revenues needed to cover a company's total

amount of fixed and variable expenses during a specified period of time. The revenues could be

stated in dollars (or other currencies), in units, hours of services provided, etc.

Figure 5: Break-even point

The break-even calculations are based on the assumption that the change in a company's

expenses is related to the change in revenues. This assumption may not hold true for the

following reasons:

A company is likely to have many diverse products with varying degrees of

profitability.

A company may have many diverse customers with varying demands for special

attention. Hence some expenses will increase for reasons other than the sale of additional

units of product.

A company may be selling in a variety of markets. This could result in the selling

prices in one market or country being lower than the selling prices in another market or

country.

The company may see frequent fluctuations in its sales mix.

The basic calculation of the break-even point in sales dollars for a year is: fixed expenses (fixed

manufacturing, fixed SG&A, fixed interest) for the year divided by the contribution margin ratio

or percentage. The basic calculation of the break-even point in units sold for a year is fixed

expenses for the year divided by the contribution margin per unit of product. 10

The break-even point formula is calculated by dividing the total fixed costs of production by the

price per unit less the variable costs to produce the product.

Since the price per unit minus the variable costs of product is the definition of the contribution

margin per unit, you can simply rephrase the equation by dividing the fixed costs by the

contribution margin.

This computes the total number of units that must be sold in order for the company to generate

enough revenues to cover all of its expenses. Now we can take that concept and translate it into

sales dollars.

The break-even formula in sales dollars is calculated by multiplying the price of each unit by the

answer from our first equation.

This will give us the total dollar amount in sales that will we need to achieve in order to have

zero loss and zero profit. Now we can take this concept a step further and compute the total

number of units that need to be sold in order to achieve a certain level profitability with out

break-even calculator.

First we take the desired dollar amount of profit and divide it by the contribution margin per unit.

The computes the number of units we need to sell in order to produce the profit without taking in

consideration the fixed costs. Now we must add back in the break-even point number of units.

Here’s what it looks like.

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The origins of break-even point can be found in the economic concepts of “the point of

indifference.”

Calculating the break-even point of a company has proved to be a simple but quantitative tool for

the managers.

The break-even analysis, in its simplest form, facilitates an insight into the fact about revenue

from a product or service incorporates the ability to cover the relevant production cost of that

particular product or service or not. Moreover, the break-even point is also helpful to managers

as the provided info can be used in making important decisions in business, for example

preparing competitive bids, setting prices, and applying for loans.

Adding more to the point, break-even analysis is a simple tool defining the lowest quantity of

sales which will include both variable and fixed costs. Moreover, such analysis facilitates the

managers with a quantity which can be used to evaluate the future demand. If, in case, the break-

even point lies above the estimated demand, reflecting a loss on the product, the manager can use

this info for taking various decisions. He might choose to discontinue the product, or improve the

advertising strategies, or even re-price the product to increase demand.

Another important usage of the break-even point is that it is helpful in recognizing the relevance

of fixed and variable cost. The fixed cost is less with a more flexible personnel and equipment

thereby resulting in a lower break-even point. The importance of break-even point, therefore,

cannot be overstated for a sound business and decision making.

However, the applicability of break-even analysis is affected by numerous assumptions. A

violation of these assumptions might result in erroneous conclusions.

Margin of Safety

Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its

market price. Another definition, In Break even analysis (accounting), margin of safety is how

much output or sales level can fall before a business reaches its breakeven point.

Using margin of safety, one should buy a stock when it is worth more than its price on the

market. This is the central thesis of value investing philosophy which espouses preservation of

capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or

neglected companies with low P/E and P/B ratios. One should also analyze financial statements

and footnotes to understand whether companies have hidden assets that are potentially unnoticed

by the market.

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Figure 6: Margin of safety

The margin of safety protects the investor from both poor decisions and downturns in the market.

Because fair value is difficult to accurately compute, the margin of safety gives the investor

room for investing. A common interpretation of margin of safety is how far below intrinsic value

one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents

for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to

a 50 percent discount to intrinsic value (pay 50 cents for a dollar).

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The margin of safety is the reduction in sales that can occur before the breakeven point of a

business is reached. This informs management of the risk of loss to which a business is subjected

by changes in sales. The concept is useful when a significant proportion of sales are at risk of

decline or elimination, as may be the case when a sales contract is coming to an end. A minimal

margin of safety might trigger action to reduce expenses. The opposite situation may also arise,

where the margin of safety is so large that a business is well-protected from sales variations.

To calculate the margin of safety, subtract the current breakeven point from sales, and divide by

sales. The formula is:

Current Sales Level – Breakeven Point

Current Sales Level

The amount of this buffer is expressed as a percentage.

Here are two alternative versions of the margin of safety:

1. Budget based- A company may want to project its margin of safety under a budget for a

future period. If so, replace the current sales level in the formula with the budgeted sales

level.

2. Unit based- If you want to translate the margin of safety into the number of units sold,

then use the following formula instead:

Current Sales Level - Breakeven Point

Selling Price Per Unit

Effect of Operating Leverage on a Company's Profits

Operating leverage, in simple terms, is the relationship between fixed and variable costs. Fixed

costs are costs that are incurred regardless of the number of units sold. Variable costs change

with the level of sales. A company with high operating leverage has a high percentage of fixed

costs to total costs, which means more units have to be sold to cover costs. A company with low

operating leverage has a high percentage of variable costs to total costs, which means fewer units

have to be sold to cover costs. In general, a higher operating leverage leads to lower profits.

Profit is defined as the difference between revenues and costs. If sales are $10,000 and costs are

$5,000, the profit is $5,000. So, the two main variables in profit are sales and costs. In general,

the more you can sell, the more profit you make. Likewise, the lower your costs, the more profit

you will have. Operating leverage helps small-business owners understand and minimize the

effect that cost structure has on company profits.

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Figure 7: associated risk with operating leverage

Cost Structure

The more operating leverage a company has, the more it has to sell before it can make a profit. In

other words, a company with a high operating leverage must generate a high number of sales to

cover high fixed costs, and as these sales increase, so does the profitability of the company.

Conversely, a company with a lower operating leverage will not see a dramatic improvement in

profitability with higher volume, because variable costs, or costs that are based on the number of

units sold, increase with volume.

Break-even Point

Operating leverage defines a company's break-even point, which drives pricing. The break-even

point is the point at which costs are equal to sales; the company "breaks even" when the cost to

produce a product equals the price customers pay for it. To make a profit, the price must be

higher than the break-even point. A company with a high operating leverage, or a higher ratio of

fixed costs to variable costs, always has a higher break-even point than a company with a low

operating leverage. The company with a high operating leverage, all other things being equal,

must raise prices to make a profit.

Benefits to High Fixed Costs

It may seem as though a high operating leverage is detrimental to profits, but a high fixed cost

structure has some benefits.

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The principal advantage is that companies with a high operating leverage have more to gain

from each additional sale because they don't have to increase costs to generate more sales. As a

result, profit margins increase at a faster pace than sales.For example, most software and

pharmaceutical companies invest a large amount in upfront development and marketing. It

doesn't matter if Microsoft or Pfizer sell one unit or 100 units, as their fixed costs will not change

much.

Effect of Operating Leverage on Net Income

The percentage change in net income based on a percentage change in sales equals DOL times

the percentage change in sales, times 100. For example, if your small business has a DOL of 7

and a 5 percent increase in sales, multiply 7 times 0.05 times 100 to get a 35 percent increase in

net income. If you instead had a lower DOL of 3 and the same sales increase, your net income

would rise by just 15 percent, or 3 times 0.05 times 100.

Effect of Operating Leverage on ROE

Because net income is the numerator of the ROE formula, operating leverage has a similar effect

on ROE as it does on net income. A higher DOL boosts ROE when sales rise, but it also

accelerates the decrease in ROE when sales decline. You can increase your DOL by increasing

your fixed costs relative to variable costs, but be aware of the negative effects on ROE when

sales decrease.

Impact of financial leverage on firm’s profitability

A company needs financial capital in order to operate its business. For most companies, financial

capital is raised by issuing debt securities and/or by selling common stock. The amount of debt

and equity that makes up a company’s capital structure has many risk and return implications.

Therefore, corporate management has an obligation to use a thorough and prudent process for

establishing a company’s target capital structure. The capital structure is how a firm finances its

operations and growth by using different sources of funds.

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Empirical Use of Financial Leverage

Financial leverage is defined as the extent to which fixed-income securities and preferred stock

are used in a company’s capital structure. Financial leverage has value due to the interest tax

shield that is afforded by the U.S. corporate income tax law. The use of financial leverage also

has value when the assets that are purchased with the debt capital earn more than the cost of the

debt that was used to finance them. Under both of these circumstances, the use of financial

leverage increases the company’s profits. With that said, if the company does not have sufficient

taxable income to shield, or if its operating profits are below a critical value, financial leverage

will reduce equity value and thus reduce the value of the company.

Given the importance of a company’s capital structure, the first step in the capital decision

making process is for the management of a company to decide how much external capital it will

need to raise to operate its business. Once this amount is determined, management needs to

examine the financial markets to determine the terms in which the company can raise capital.

This step is crucial to the process, because the market environment may curtail the ability of the

company to issue debt securities or common stock at an attractive level or cost. With that said,

once these questions have been answered, the management of a company can design the

appropriate capital structure policy, and construct a package of financial instruments that need to

be sold to investors. By following this systematic process, management’s financing decision

should be implemented according to its long-run strategic plan, and the manner in which it wants

to grow the company over time.

Impact of Financial Leverage on Performance

Perhaps the best way to illustrate the positive impact of financial leverage on a company’s

financial performance is by providing a simple example. The Return on Equity (ROE) is a

popular fundamental used in measuring the profitability of a business as it compares the profit

that a company generates in a fiscal year with the money shareholders have invested. After all,

the goal of every business is to maximize shareholder wealth, and the ROE is the metric of return

on shareholder's investment.

Measurement of Financial Leverage Risk

Corporate management tends to measure financial leverage by using short-term solvency ratios.

Like the name implies, these ratios are used to measure the ability of the company to meet its

short-term obligations. Two of the most utilized short-term solvency ratios are the current ratio

and acid-test ratio. Both of these ratios compare the company’s current assets to its current

liabilities. However, while the current ratio provides an aggregated risk metric, the acid-test ratio

provides a better assessment of the composition of the company’s current assets for purposes of

meeting its current liability obligations since it excludes inventory from current assets.

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Capitalization ratios are also used to measure financial leverage. While there are many

capitalization ratios that are used in the industry, two of the most popular metrics are the long-

term-debt-to-capitalization ratio and the total-debt-to-capitalization ratio. The use of these ratios

is also very important for measuring financial leverage. However, these ratios can be easily

distorted if management leases the company’s assets without capitalizing the assets' value on the

company’s balance sheet . Moreover, in a market environment where short-term lending rates are

low, management may elect to use short-term debt to fund both its short- and long-term capital

needs. Therefore, short-term capitalization metrics also need to be used to conduct a thorough

risk analysis.

Coverage ratios are also used to measure financial leverage. The interest coverage ratio, also

known as the times-interest-earned ratio, is perhaps the most well-known risk metric. The

interest coverage ratio is very important because it provides an indication of a company’s ability

to have enough pre-tax operating income to cover the cost of its financial burden. The funds-

from-operations-to-total-debt ratio, and the free-operating-cash-flow-to-total-debt ratio are also

important risk metrics that are used by corporate management.

How the Degree of Financial Leverage Affects Earnings Per Share

The DFL determines the percentage change in a company's EPS per unit change in its EBIT. A

company's DFL is calculated by dividing a company's percentage change in EPS by the

percentage change in EBIT over a certain period. It could also be calculated by dividing a

company's EBIT by its EBIT less interest expense.

EPS is used in fundamental analysis to determine a company's profitability. EPS is calculated by

subtracting dividends paid out to shareholders from a company's net income. The resulting value

is divided by the company's average outstanding shares.

A higher DFL ratio means that the company's EPS is more volatile. For example, assume

hypothetical company ABC has EBIT of $50 million, an interest expense of $15 million and

outstanding shares of 50 million in its first year. Company ABC's resulting EPS is 70 cents, or

($50 million - $15 million) / (50 million).

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We have followed the following process for performing the analysis of leverage of BATBC:

Chapter 3: Application to theory

Analyzing the income

statement of BATBC

Adjusting the

income statement

for performing

analysis

Analyzing the effect of

leverage on EPS and

EBIT

Performing scenario analysis

The income statement of BATBC

Adjusted variables:

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2010 2011 2012 2013 2014 2015

WPPF 215.429 258.614 342.182 479.141 571.909 655.767

Operating profit 4324.72 5282.96 6912.7 9504.37 11536.7 13200.5

WPPF as a percentage of OP 0.04981 0.04895 0.0495 0.05041 0.04957 0.04968

Average 0.04965

net sales 20946 23268.9 27471.3 31225.4 35642 39894.9

sales volume 22245.7 25404.9 30400 36942.8 42749.1 48448.9

price 0.94158 0.91592 0.90366 0.84524 0.83375 0.82344

Average price 0.87726

per unit contribution margin 0.32514

variable cost:

COGS 13475.7 13455.5 15946.2 17501.3 19332.2 21212.5

WIPP 214.744 262.325 343.25 471.939 572.852 655.471

Total 13690.4 13717.9 16289.5 17973.3 19905.1 21868

variable cost as a percent of sale0.65361 0.58954 0.59296 0.5756 0.55847 0.54814

Average VC % 0.58639

average VC per unit 0.55213

Fixed operating cost:

Operating expense 3145.63 4530.37 4612.42 4219.74 4775.12 5481.86

Depreciation 0 0 627.605 768.565 948.318 0

total fixed operating cost 3145.63 4530.37 5240.02 4988.3 5723.44 5481.86

Average fixed operating cost 4851.6

Fixed financing cost 16.145 110.687 119.878 11.215 157.346 122.828

Average Fixed financing cost 89.6832

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Effect of leverage on EPS and EBIT:

% Change % change % change

in sales DOL in OP DFL in NI DTL

2.506594 1.028648 2.578402

0.142012 2.111086 0.355965 1.020969 0.366163 2.155354

0.19662 1.785175 0.415081 1.014728 0.423785 1.811467

0.215224 1.567236 0.384213 1.010597 0.389871 1.583843

0.157169 1.455128 0.246322 1.008485 0.248932 1.467474

0.133332 1.381175 0.194015 1.007096 0.195661 1.390975

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% increase in operating profit=%increase in sales* DOL

% increase in Net income = %increase in Operating profit* DFL

% increase in Net income = %increase in sales* DTL

Impact of leverage on breakeven :

Case 1: Average level of leverage:

Case 2: 1.5 times of the Average level of leverage:

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0

5000

10000

15000

20000

25000

30000

35000

40000

45000

BREAKEVEN GRAPH

sales fixed cost total cost Log. (sales)

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

BREAKEVEN GRAPH

sales fixed cost total cost Log. (sales)

Case 3: 0.80 times of the Average level of leverage:

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0

5000

10000

15000

20000

25000

30000

35000

40000

45000

BREAKEVEN GRAPH

sales fixed cost total cost Log. (sales)

Conclusion:

A company needs financial capital in order to operate its business. For most companies, financial

capital is raised by issuing debt securities and/or by selling common stock. The amount of debt

and equity that makes up a company’s capital structure has many risk and return implications.

Therefore, corporate management has an obligation to use a thorough and prudent process for

establishing a company’s target capital structure. The capital structure is how a firm finances its

operations and growth by using different sources of funds.

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