Chapter 4 Measures of Leverage

Chapter 4Measures of leveragePresenters namePresenters titledd Month yyyy11. IntroductionLeverage is the use of fixed costs in a companys cost structure.Operating leverage relates to the companys operating cost structure.Financial leverage relates to the companys capital structure.Copyright 2013 CFA Institute2Fixed Costs

Fixed CostsLOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Page 171

Introduction

Leverage is the use of fixed costs relative to variable costs. Operating leverage pertains to the mix of fixed and variable costs of production.Financial leverage pertains to the capital structure (how the company finances its business).2Why worry about leverage?A companys use of leverage affects its risk and return.Operating leverage and financial leverage provide insight into a companys business and its future.Leverage helps us understand a companys future cash flows and the risk associated with those cash flows and, hence, its valuation.Copyright 2013 CFA Institute3Pages 172173

Why Worry About Leverage?

From an analyst point of view, leverage affects the companys risk (both total and systematic). 32. LeverageCopyright 2013 CFA Institute4Leverage increases the volatility of earnings and cash flows hence, it increases risk to suppliers of capital (creditors and owners).Consider two companies, Company One and Company Two, with the following information:

Company OneCompany TwoNumber of units produced and sold1,0001,000Sales price per unit250250Variable cost per unit12525Fixed operating cost50,000100,000Fixed financing expense5,00055,000Debt50,000550,000Equity700,000200,000Total assets750,000750,000LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 172173

2. Leverage

Leverage is the use of fixed costs in the cost structure (relative to variable costs). The greater the reliance on fixed costs (relative to variable costs), the more leverage and the more potential volatility of earnings. 4What does leverage do exactly?Copyright 2013 CFA Institute5Company Two uses more operating and financial leverage than Company One.LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Page 172175

What Does Leverage Do Exactly?

Changes in units produced and sold affects not only operating earnings volatility, but also net income as well. The combined effect makes Company Two more profitable with more units produced and sold, but also riskier (similar to Exhibit 4-3).We can use simulations to get a better idea of the risk created by leverage (see Exhibit 4-4).53. Business risk and financial riskBusiness risk is the risk associated with the volatility in operating earnings. Business risk is composed of both operating and sales risk.Sales risk is the uncertainty associated with the number of units produced and sold, as well as the sales price.Copyright 2013 CFA Institute6LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 173175

3. Business Risk and Financial Risk

Business risk encompasses sales risk and operating risk. Sales risk pertains to how many units will be sold and at what price.

Discussion question: What is an example of a company with a high level of sales risk?

6Operating riskOperating risk is the risk associated with the mix of variable and fixed operating expenses.Operating risk is the sensitivity (i.e., elasticity) of operating earnings to changes in unit sales.The degree of operating leverage (DOL) is the ratio of the percentage change in operating income to the percentage change in units sold.The per unit contribution margin is the difference between the sales price and the variable cost per unit. This difference is available to cover fixed operating costs.Overall, for all units sold, the contribution margin is the difference between total revenues and variable operating costs.

Copyright 2013 CFA Institute7LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 176181

Operating Risk

Operating risk affects operating earnings. The greater the relative use of fixed operating costs, relative to variable costs, the greater the leverage and, hence, the risk. The DOL is the elasticity of operating earnings with respect to the change in units sold. The DOL is for a specific number of units produced and sold.The contribution margin can be stated as a per unit amount or as a total amount for a given level of sales.

7DOLCopyright 2013 CFA Institute8LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 176178

DOL

The DOL is at a specific number of units produced and sold; the DOL will vary with Q (see Exhibit 4-6 in the text).Note: F, the fixed operating cost, is the fulcrum in this type of leverage.

Discussion question: What would be an example of a company with a high degree of operating leverage?

8Example: Company One and Company TwoCopyright 2013 CFA Institute9LOS: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.Pages 176181

Example: Company One and Company Two

Company Two has more operating risk.A 1% change in unit sales would have a 1.667% change in operating earnings of Company One and a 1.8% change in operating earnings of Company Two.9Financial riskFinancial risk is the risk associated with the choice of financing the business.The greater the reliance on fixed-cost obligations, such as debt, the greater the financial risk.Similar to operating risk, financial risk elasticity is the sensitivity of income available to owners to a change in operating earnings.The degree of financial leverage (DFL) is the ratio of the percentage change in net income to the percentage change in operating income.Copyright 2013 CFA Institute10LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 182184

Financial Risk

Financial risk is associated with the companys capital structure. The greater the use of fixed-cost financing (i.e., debt), the greater the financial leverage and, hence, risk. The DFL is the elasticity of earnings available to owners with a change in operating earnings. The DFL is specific for a given level of operating earnings (and, therefore, Q). 10DFLCopyright 2013 CFA Institute11LOS: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description.Pages 182184

DFL

The greater the fixed financial cost, C, the greater the DFL and, therefore, financial risk. The DFL is a choice of the companys management, whereas DOL is affected, in large part, by the companys line of business.

Discussion question: What is an example of a company with a high degree of financial leverage?11Example: Company One and Company TwoCopyright 2013 CFA Institute12LOS: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.Pages 182184

Example: Company One and Company Two

Company Two has more financial risk.A 1% change in operating earnings would have a 1.071% change in net income of Company One, and a 1.786% change in net income of Company Two.Note: The denominator for the DOL becomes the numerator in the DFL.12Return on equity and the DFLThe greater the degree of financial leverage, the greater the financial risk.We can see the leveraging effect by looking at the return on equity (ROE) for different levels of units produced and sold.The greater the DFL, the more sensitive the ROE is to changes in the units produced and sold.Copyright 2013 CFA Institute13LOS: Describe the effect of financial leverage on a companys net income and return on equity.Pages 182185

Return on Equity and the DFL

The DFL and the volatility of the return on equity are directly related because DFL is the elasticity of earnings available to owners to changes in operating earnings.See Example 4-3.13Example: Return on equityConsider the example of Company One and Company Two:

Copyright 2013 CFA Institute14LOS: Describe the effect of financial leverage on a companys net income and return on equity.Pages 182184, 186

Example: Return on Equity

Similar to Exhibit 4-12 (Capital Company example).The slope for Company Two is steeper, indicating more sensitivity of ROE to changes in units produced and sold.14Degree of Total LeverageCopyright 2013 CFA Institute15LOS: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.Pages 184188

The Degree of Total Leverage

The degree of total leverage has the numerator from the DOL and the denominator from the DFL (Equation 4-5).The DTL is the elasticity of earnings to owners to changes in units produced and sold (Q). Note: The fulcrum is the sum of F and C (the fixed operating and financial costs).

15Example: Company One and Company TwoCopyright 2013 CFA Institute16LOS: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.Pages 184188

Example: Company One and Company Two

Company Two has more total risk.A 1% change in operating earnings would have a 1.786% change in net income of Company One and a 3.214% change in net income of Company Two.16Breakeven QuantityCopyright 2013 CFA Institute17LOS: Calculate the breakeven quantity of sales and determine the companys net income at various sales levels.LOS: Calculate and interpret the operating breakeven quantity of sales.Pages 189191

Breakeven Quantity

The breakeven quantity indicates when net income is zero. The operating breakeven quantity indicates when operating income is zero.

Discussion question: Why would an analyst want to estimate a breakeven point for a company?17Example: Company One and Company TwoCopyright 2013 CFA Institute18LOS: Calculate the breakeven quantity of sales and determine the companys net income at various sales levels.LOS: Calculate and interpret the operating breakeven quantity of sales.Pages 189191

Example: Company One and Company Two

Company Two has more total risk.A 1% change in operating earnings would have a 1.786% change in net income of Company One, and a 3.214% change in net income of Company Two.18Risks to creditors and ownersCopyright 2013 CFA Institute19Business risk is affected by demand uncertainty, output price uncertainty, and cost uncertainty.Financial risk adds to the companys business risk, increasing the risk to creditors and owners.The creditor claims are fixed, whereas the equity claims are residual.In the event that creditor claims cannot be satisfied, there may be legal statuses that help sort out the claims:Reorganization is the restructuring of claims, with the expectation that the company will be able to continue, in some form, as a going concern.Liquidation is the situation in which assets are sold and then the proceeds distributed to claimants. Pages 191193

Risks to Creditors and Owners

In the United States, reorganization is under Chapter 11 of the U.S. Bankruptcy Code. Example: General Motors.Liquidation is under Chapter 7. Example: Circuit City (U.S.).194. SummaryLeverage is the use of fixed costs in a companys cost structure. Business risk is the risk associated with operating earnings and reflectssales risk (uncertainty with respect to the price and quantity of sales) andoperating risk (the risk related to the use of fixed costs in operations). Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity and debt financing of the business).

Copyright 2013 CFA Institute204. Summary

20Summary (continued)The degree of operating leverage (DOL) is the sensitivity of operating earnings to changes in units produced and sold.The degree of financial leverage (DFL) is the sensitivity of cash flows to owners to changes in operating earnings.The degree of total leverage (DTL) is the sensitivity of the cash flows to owners to changes in unit sales.The breakeven point, QBE, is the number of units produced and sold at which the companys net income is zero.The operating breakeven point, QOBE, is the number of units produced and sold at which the companys operating income is zero.

Copyright 2013 CFA Institute214. Summary21