Chapter 3, Leverage

Addis Ababa University / Department of Accounting and Finsnce
Chapter Four: Capital Structure theory and leverage.

The capital structure question
It is a question of how should a firm go about choosing its debt/equity ratio. Is there an
optimum capital structure that maximizes firm’s value? Capital structure and cost of
capital relationships. The value of the firm is maximized when the WACC is minimized.
WACC is the discount rate that is appropriate for the firm’s overall cash flows and values
and discount rate move in opposite directions, minimizing the WACC will maximize the
value of the firm’s cash flows.
There are two kinds of leverage in finance: operating leverage and financial leverage
Operating leverage.
Operating leverage refers to magnifying gains and losses in earnings before interest and
taxes (EBIT) by changes that occur in sales. This magnification occurs because in
employing assets the firm incurs certain fixed costs, costs unrelated to the sales volume
created by the assets. Operating costs can be divided into variable and fixed costs. As
sales changes, variable costs change proportionally. This means the variable cost ratio to
sales is constant. This is true over some relevant range of sales. Variable cost includes
material, direct labor, repair and maintenance expenses. Fixed operating costs are
independent of sales level in the short run and over the relevant sales range. In the long
run all costs are variable. Fixed costs include depreciation, indirect labor cost, overhead
costs.
Degree of Operating Leverage (DOL)
Degree of operating leverage is computed as:
DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
DOL at base sales level Q = Q (P-V)
Q (P-V)-F where, Q is quantity, P is price,
V is variable cost and F is fixed cost
Example,
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of out put (Q) is 8,000 and increase to 10,000 units.
Required:
Determine DOL?
Solution:
EBIT= Q (P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Financial Management II/ Chapter Four-Leverage 1

Percentage change in out puts = (10,000-8,000)/8,000=25%

DOL= %ΔEBIT
%Output
66.67%/25%=2.67
Or
1+ F
EBIT
1+ 30,000/18,000=2.67
Or
= Q (P-V)
Q (P-V)-F
=8,000(10-4)
8,000(10-4)-30,000
=2.67
The coefficient of operating leverage of 2.67 is interpreted as a 1% change in out put

form the current base levels, there will be a 2.67% change in EBIT in the same direction
as the out put (sales) change. If out put (sales) increase by 10%, EBIT will increase by
26.7% (10x 2.67%). Similarly, if out put (sales) decrease by 10%, EBIT will decrease by
26.7%. Other things equal, the higher the fixed costs relative to variable costs, the higher
the operating leverage.
Example,
AA firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the
annual interest expense is $90,000. What is this firm’s degree of operating leverage
(DOL)?
Solution
DOL = Q (P-V) = 150,000(10-6.50)

Q (P-V)-F 150,000(10-6.50)-150,000
=1.4
Breakeven analysis:
The sales level that corresponds with a zero EBIT level is called the break-even sales
level.
EBIT= SALES- VARIABLE COST- FIXED COST
0 =P.Q-V.Q-FC
0 = Q(P-V)-FC
Q (P-V) = FC
Q = FC
P-V
Example,

P = 10
V=4
FC = 90,000
Required: Determine operating break even in units and sales?
Q = FC
P-V
= 90,000/ (10-4) = 15,000 units. Sales = 10x 15,000 =150,000
Note that the coefficient of operating leverage at operating break even has undefined
value.
Example,
Compute EBIT and coefficient of operating leverage when Q is 10,000 units?
Solution:
EBIT= Q (P-V)-F = 10,000 (10-4) - 90,000= (30,000)
DOL = Q (P-V) = 10,000(10-4)
Q (P-V)-F 10,000(10-4)-90,000
=2
Or
DOL =1+ F = 1 + 90,000
EBIT (30,000)
1-3= 2
Note: -Technically, the formula for DOL should include absolute value signs because it is
possible to get a negative DOL when the EBIT for the base sales level is negative. Since
we assume that the EBIT for the base level of sales is positive, the absolute value signs
are not included. Because the concept of leverage is linear, positive and negative
changes of equal magnitude
Break even analysis limitation:

1. There is a narrow range of sales over which expects fixed costs to be actually
fixed.
2. It is only helpful when there is linear relationship among variable, EBIT and
sales.
Financial risk and financial leverage
Financial Leverage
Operating leverage refers to the fact that a lower ratio of variable cost per unit to price
per unit causes profit to vary more with a change in the level of output than it would if
this ratio was higher. Financial leverage refers to the fact that a higher ratio of debt to
equity causes profitability to vary more when earnings on assets changes than it would if
this ratio was lower. Obviously, the profits of a business with a high degree of both kinds
of leverage vary more, everything else remaining the same, than do those of businesses
with less operating and financial leverage. Greater variability of profits, of course, means
risk is higher. Therefore, in deciding what the optimum level of leverage is, what is an
acceptable risk/return tradeoff must be determined
Financial leverage is created by financing with sources of capital that have fixed costs.

The major sources of fixed charges financing are debt (requiring interest payment) and
preferred stock require dividend payment and leases which require lease payments. These
financing fixed costs affect the firm’s earning per share (EPS) in the same way that
operating fixed costs affect EBIT. The more fixed charge financing the firm uses, the
more financial leverage it will have.
Degree of Financial leverage:

Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.
DFL = %Δ in EPS
%Δ in EBIT
Where, EPS is earning per share
EPS = (EBIT-I) (1-T)-D

N
Where, N is number of common stock outstanding shares.
Or
DFL = EBIT
EBIT-I-L-D/ (1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate
Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore,
dividend payment has to be adjusted by dividing with (1-T) to make it on equivalent
basis.
Example,
A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed
costs are $1,250,000, and the annual interest expense is $100,000. The firm paid 80,000
for preferred stock holders and has 60,000 outstanding shares of common stock. The firm
tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1. EPS = (EBIT-I) (1-T)-D
N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
=2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:

EBIT = 600,000(10-6.50)-1,250,000=850,000
EPS = (850,000-100,000) (1-0.4)-80,000
60,000
=6.16
DFL = %Δ in EPS
%Δ in EBIT
= (6.16-2.67)/2.67
(850,000-500,000)/500,000
=1.307/0.7= 1.87
or
DFL = EBIT
EBIT-I-L-D/ (1-T)
= . 500,000 .
500,000-100,000- 80,000/(1-0.4)
=1.87
Financial break even
It is defined as the value of EBIT that makes EPS equal to zero. At financial break even,
the firm’s EBIT is just sufficient to cover its fixed financing costs (interest and preferred
Stock dividends) on a before tax basis leaving no earnings for common shareholders.
(EBIT-I)(1-T)-D= EPS
N
(EBIT-I)(1-T)-D= 0 (EBIT-I)(1-T)-D = 0
N EBIT-I = D
(1-T)
EBIT= D +I
(1-T)
Effect of Financial leverage on EPS

Example,
Suppose, a new firm, ABC Company, is just now considering financing plans. The firm
needs birr 100,000 of long term capital to begin operations and has narrowed the choice
to two financing plans:
Alternative 1: sell 1,000 shares of common stock at birr 100 per share.
Alternative 2: sell 500 shares of common stock at birr 100 per share and borrow birr
50,000 from the bank at 5% interest.
Alternative 1 is an all equity plan. The company’s long term debt to equity ratio would be
zero. Alternative 2 involves the sales of equal amounts of debt and equity, and the firm’s
long-term debt to equity ratio to be one. What effect would these plans have on ABC
EPS? It depends on the relationship between the before tax cost of debt and the rate of
return on assets before interest and taxes. Most firm’s EBIT influenced by general
economic conditions. If the economy is strong, EBIT will be favorable, and if the
economy is weak, EBIT will be unfavorable. ABC estimates that if the economy is weak,

EBIT will be 4,000; if the economy is about average, EBIT will be birr 6,000; and if the
economy is strong, EBIT will be birr 8,000. Theses estimates imply that ABC’s return on
asset before interest and tax (EBIT/ Total asset) will be 4%(4,000/100,000) in weak
economy, 6 percent in an average economy, and 8 percent in a strong economy. In
comparison, the before tax cost of debt is 5%.
Economic conditions:
Weak Average strong
Alternative 1: all equity financing (debt: equity ration=0)
EBIT 4,000 6,000 8,000
INTEREST 0 0 0
EBT 4,000 6,000 8,000
TAX(50%) 2,000 3,000 4,000
NI 2,000 3,000 4,000
NO OF SHARES COMMON 1,000 1,000 1,000
EPS 2 3 4
Alternative 2: 50%equity and 50% debt financing (debt: equity ration=1)

EBIT 4,000 6,000 8,000
INTEREST 2,500 2,500 2,500
EBT 1,500 3,500 5,500
TAX(50%) 750 1,750 2,750
NI 750 1,750 2,750
NO OF SHARES COMMON 500 500 500
EPS 1.5 3.5 5.5
Indifference point EBIT- EPS analysis:

The effect of financial leverage on EPS depends on the relationship between the before
tax cost of debt and the EBIT rate of return on assets.
In a weak economy, EPS is higher under the all equity alternative. But in either an
average or a strong economy, EPS pf alternative 2 is higher. Actually, alternative 2result
in higher EPS so long as EBIT/ TA are greater than the before tax cost of debt of 5%
Alternative 2
5
EPS 4 Alternative 1
3
2
1
0 1 2 3 4 5 6 7 8
EBIT (birr 000)
Figure 2.1

We can also algebraically solve for EBIT at the indifference point. By definition:
EPS = (EBIT-I) (1-T)-D
N
Alternative 1: EPS 1 = (EBIT-0) (1-0.5)-0 = 0.0005EBIT
1,000
Alternative 2: EPS 2 = (EBIT-2,500) (1-0.5)-0 = 0.0001EBIT-2.5

500
The indifference point is where the two EPS’ are equal.
0.0005EBIT = 0.0001EBIT-2.5
EBIT= 5,000birr
Effect of financial leverage on financial risk and expected EPS

In this section we relate expected EPS and financial risk to stock price. Let us assume
ABC’s EBIT outcomes are equally likely, and then the probability of each is one third.
EPS
EBIT Probability Alternative 1 Alternative 2
4,000 1/3 2 1.50
6,000 1/3 3 3.50
8,000 1/3 4 5.50
Required: compute expected EPS and standard deviation of each alternative.
Expected EPS = EPS x Probability
Alternative 1: expected EPS= 1/3 x 2 + 1/3x 3 + 1/3x 4 =3
Standard deviation= 1/3(2-3)2 + 1/3(3-3)2 + 1/3(4-3)2
=0.82
Alternative 2: expected EPS= 1/3 x 1.5 + 1/3x 3.50 + 1/3x 5.5 =3.50
Standard deviation= 1/3(1.5-3.5)2 + 1/3(3.5-3.5)2 + 1/3(5.5-3.5)2
=1.63
When we see the two alternatives, note that there are two effects of financing with debt.
That is there are two effects of financial leverage:
1. Expected earnings per share increases
2. The standard deviation of earnings per share increases. These two conclusions
have important valuation implications. The firm’s ability to pay dividend is
directly related to its expected EPS. The greater the expected EPS, the greater the
firm’s future expected dividends will be.
Remark: increased financial leverage= increase expected EPS= increase standard
deviation= increase stock riskiness.

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Addis Ababa University / Department of Accounting and Finsnce

Chapter Four: Capital Structure theory and leverage.

Financial Management II/ Chapter Four-Leverage 1

Percentage change in out puts = (10,000-8,000)/8,000=25%

The coefficient of operating leverage of 2.67 is interpreted as a 1% change in out put

DOL = Q (P-V) = 150,000(10-6.50)

Financial Management II/ Chapter Four-Leverage 2

Break even analysis limitation:

Financial Management II/ Chapter Four-Leverage 3

Degree of Financial leverage:

EPS = (EBIT-I) (1-T)-D

Financial Management II/ Chapter Four-Leverage 4

Effect of Financial leverage on EPS

Financial Management II/ Chapter Four-Leverage 5

Alternative 2: 50%equity and 50% debt financing (debt: equity ration=1)

Indifference point EBIT- EPS analysis:

Financial Management II/ Chapter Four-Leverage 6

Alternative 2: EPS 2 = (EBIT-2,500) (1-0.5)-0 = 0.0001EBIT-2.5

Effect of financial leverage on financial risk and expected EPS

Financial Management II/ Chapter Four-Leverage 7

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