1. Leverage Analysis

2. Leverage Analysis • In physics, leverage refers to a multiplcation of a force into even larger forces • In finance, it is similar, but we are refering to a multiplication of %changes in sales into even larger changes in profitability measures

3. Types of Risk • There are two main types of risk that a company faces: • Business risk - the variability in a firm’s EBIT. This type of risk is a function of the firm’s regulatory environment, labor relations, competitive position, etc. Note that business risk is, to a large degree, outside of the control of managers • Financial risk - the variability of the firm’s earnings before taxes (or earnings per share). This type of risk is a direct result of management decisions regarding the relative amounts of debt and equity in the capital structure

4. Factors that influence Business Risk • Uncertainty about demand (unit sales). • Uncertainty about output prices. • Uncertainty about input costs. • Product and other types of liability. • Degree of operating leverage (DOL).

5. Income Statement

6. The Degree of Operating Leverage (DOL) • The degree of operating leverage is directly proportional to a firm’s level of business risk, and therefore it serves as a proxy for business risk • Operating leverage refers to a multiplication of changes in sales into even larger changes in EBIT • Note that operating leverage results from the presence of fixed costs in the firm’s cost structure

7. Calculating the DOL • The degree of operating leverage can be calculated as: • This approach is intuitive, but it requires two income statements to calculate • We can also calculate DOL with one income statement:

8. Rev. Rev. $ $ } TC EBIT TC F F QBE QBE Sales Sales • Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline.

9. The Degree of Financial Leverage (DFL) • The degree of financial leverage is a measure of the % changes in EBT that result from changes in EBIT, it is calculated as: • This approach is intuitive, but it requires two income statements to calculate • We can also calculate DFL with one income statement:

10. Consider Two Hypothetical Firms Firm UFirm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

11. Impact of Leverage on Returns Firm U Firm L EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800$1,080 ROE 9.0% 10.8%

12. Why does leveraging increase return? • More EBIT goes to investors in Firm L. • Total dollars paid to investors: • U: NI = $1,800. • L: NI + Int = $1,080 + $1,200 = $2,280. • Taxes paid: • U: $1,200; L: $720. • Equity $ proportionally lower than NI.

13. The Degree of Combined Leverage (DCL) • The degree of combined leverage is a measure of the total leverage (both operating and financial leverage) that a company is using: • It is important to note that DCL is the product (not the sum) of both DOL and DFL

14. Calculating Leverage Measures