Chapter 10: Financial & Operating Leverage · Chapter 10: Financial & Operating Leverage 2014 11 Ibrahim Sameer Bachelors of Business – HRM (FM – Cyryx College) Question 4 Question

Chapter 10: Financial & Operating Leverage 2014

1 Ibrahim Sameer Bachelors of Business – HRM (FM – Cyryx College)

Financial Management

Bachelors of Business (Specialized in

HRM) – Study Notes

Chapter 10: Financial & Operating

Leverage



INTRODUCTION

This topic provides an overview of a firm's capital structure. More specifically, the topic

discusses leverage and capital structure theories. A firm's leverage can be further divided into

operating leverage, financial leverage and total leverage.

OVERVIEW OF FIRM’S CAPITAL STRUCTURE

When a firm expands its business, the capital requirements that arise from the Firm’s expansion

can be met by basic sources, namely equity and debt financing. However, in choosing an

appropriate capital structure, the firm's management needs to evaluate the benefits of each type

of capital structure in order to bring the most value to the firm. The following table summarises

the effects of debt financing on a firm's capital structure.

Advantages and Disadvantages of Debt Financing

The most appealing characteristic of debt financing throughout the years has been that the

interest paid on debt financing is tax deductible. Furthermore, as debt financing requires

servicing the debt through fixed payments or charges, stockholders do not have to share their

profits if the business is extremely successful. However, it is important to note that the use of

debt financing also has its disadvantages.

Firstly, a higher debt ratio will increase a firm's leverage. In addition, the firm is obligated to

service interest and principal on a timely basis. This accumulation of risk is jeopordising the

firm's capital structure. Consequently, the cost of capital increases should the firm wish to

borrow again. Secondly, when the firm faces difficulties, the firm may not be able to generate

sufficient operating cash flow in order to cover interest possibly resulting in bankruptcy.



Therefore, a company with volatile income and operating cash flows limits the uses of debt

financing, as the perceived tax gains are offset by the higher risks of bankcruptcy. The company

with a more stable income which is able to cover regular fixed interest payments would be better

positioned to take advantage of the tax breaks offered by debt financing.

TYPES OF RISK AND FIRM’S LEVERAGE

Businesses encounter two types of risk arising from operating and financing activities. These are

business risks and financial risks, which are discussed in the following sections.

Business Risk and Operating Leverage

Business risk is a stand-alone risk associated with a firm’s business activity. It is the function of

the inherent uncertainty in a projection of a firm’s returns on invested capital.

Businesses are varied not only from industry to industry, but also among the firms in a given

industry. Therefore, business risk can be varied across industries, and across companies within

an industry. Business risk depends on a number of factors. Most important of these factors are

variability of earnings and accumulation of fixed cost. The extent to which cost is fixed in

operating activities is called operating leverage. A framework for analysing business risk and a

firm's leverage is detailed in the following sections.

(a) Operating Leverage and Business Risk

Operating leverage can also be defined as the sensitivity of operating income to changes in sales.

Business risk depends on the extent to which a firm builds fixed costs into its operation.

High operating leverage implies that changes in sales will cause proportionally higher changes in

operating income. A small decline in a firm's sales may also lead to proportionately higher

decline in the firm's income as the firm incurs fixed costs irrespective of their level of sales.

Therefore, as the level of sales drops, so too does the level of profitability. As a result, returns to

its shareholders (ROE) may also drop.

Operating leverage works in both ways, i.e. if a firm has fixed operating costs, an increase in

sales will result in a more-than-proportional increase in EBIT (Earnings before interest and tax),

and a decrease in sales will result in a more-than-proportional decrease in EBIT.

Mathematically, the degree of such a relationship can be stated as follows:



Or the degree of operating leverage can also be stated on base level:



Fixed Costs and Operating Leverage

Changes in fixed operating costs will affect operating leverage significantly. If, for example, a

firm can shift some of its variable costs to fixed costs, it will increase the DOL and magnify the

relationship between sales and EBIT even further.

Example 3.3

Assume a firm with: FC = MVR2,500; P = MVR10; VC = MVR5, and a current Q of 1,000

units.

Now assume that the following changes are observed:

VC reduced to MVR4.50/unit



FC increased to MVR3,000

This indicates that the 1 percentage point increase in sales will lead to a 2.2 percentage point

increase in the firm’s EBIT. You can see from the example now that the relationship is further

magnified as a result of a shift in variable cost to fixed cost. Therefore, increase in fixed

operating cost may result in high variability of the relationship between sales and EBIT.

(b) Financial Risk and Financial Leverage

Financial risk is the additional risk placed on common stockholders as a result of the decision to

finance the capital requirement with debt. Normally, the stockholders face a certain amount of

risk that is inherent in a firm's operation, which is business risk. Thus, the use of financial

leverage concentrates the firm's business risk on its stockholders. This concentration of business

risk occurs because debt holders who receive fixed interest payments bear none of the finance

risk.

Financial leverage comes from the use of fixed interest payments on debt financing. Financial

leverage also can be defined as the sensitivity of net income to changes in the operating income.

Financial leverage also works both ways, i.e. an increase in the firm's EBIT will result in a more-

than-proportional increase in the firm's EPS, and vice versa, as long as the firm is using fixed

financing costs (interest and preferred dividend payment).

(i) Types of Financing Cost

There are two types of fixed financial costs common to firms. These are summarised in Figure

3.1.



Interest on debt is an interest-expense incurred by firms issuing debt instruments. Interest

expenses are more periodic with fixed financing cost.

Preferred stock dividend is an income for preferred stockholders. The preferred stock dividends

are fixed and paid periodically. However, a firm might not pay dividends for certain periods if

the firm faces financial problems.

Generally, most firms tend to pay regular preferred stock dividends. Therefore, it is important to

examine the extent to which a change in a firm's EBIT results from a change in a firm's EPS with

fixed financing cost. Numerical measures for such relations can be explained by the degree of

financial leverage.

(ii) Degree of Financial Leverage (DFL)

Fixed financial costs must be paid regardless of how much EBIT there is available to pay them.





………………… END………………...



Practice Questions

Question 1

A firm expects an increase in sales of 25%. If the firm’s degree of operating leverage is 2 times,

what should be the percentage point changes in the firm’s EBIT?

Question 2

A firm expects its earnings per share to be increased by 20%. If the firm’s degree of financial

leverage is 1.5 times, how many percentage points of the firm’s EBIT should be increased in

order to realise 20% increase in earnings per share?

Question 3



Question 4

Question 5

Question 6

Calculate the degree of operating leverage (DOL) at 400,000 units of quantity sold. The firm has

$1,000,000 in fixed costs. The firm anticipates selling each unit for $25 with variable costs of $5

per unit.

Question 7

Calculate the degree of total leverage (DTL) for a firm that has $10 million in sales. The firm has

EBIT of $2,000,000 after accounting for $1,000,000 in fixed costs. The firm has $3,000,000 in

debt that costs 10% annually. The firm also has a 9%, $1,000,000 preferred stock issue

outstanding. The firm pays 40% in taxes.

Question 8

Milwaukee Melon Manufacturers sells exotic melons at one price, $10 each. The firm has

variable costs of $160,000 on sales of 32,000 melons. Fixed costs are $80,000. Operating income

(EBIT) this year is $80,000 and after-tax net income is $30,000. Interest expense is $20,000.

a. What is its degree of financial leverage at the current level of EBIT?

b. Suppose that EBIT were to decline 10 percent next year. What would be the percentage

decline in earnings per share (EPS)?

Documents

Chapter 10: Financial & Operating Leverage · Chapter 10: Financial & Operating Leverage 2014 11 Ibrahim Sameer Bachelors of Business – HRM (FM – Cyryx College) Question 4 Question