Impact and Analysis of Leverage

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Impact and Analysis

of Leverage

Impact and Analysis

of Leverage

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What is

Leverage?

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What is

Leverage?

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Two concepts that

enhance our

understanding of risk...

1)

Operating Leverage

- affects

a firm’s

business risk

.

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Business Risk

 The variability or uncertainty of a

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Analytical Income Statement

sales

- variable costs - fixed costs

operating income (EBIT) - interest

EBT - taxes

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Business Risk

Affected by:

 Sales volume variability

 Competition

 Product diversification

 Operating leverage

 Growth prospects

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EBIT

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Financial Risk



The

variability or uncertainty of a

firm’s earnings per share (EPS)

and the increased probability of

insolvency that arises when a

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Financial Leverage



The use of

fixed-cost

sources of

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EPS

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Financial Leverage

 Used as a means of increasing the

return to common shareholders.

Financial Leverage

-- The use of

_{-- The use of}

fixed financing costs by the firm.

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Financial Leverage



Financial leverage

: by using

fixed cost financing, a small

change in operating income is

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EBIT-EPS Break-Even,

EBIT-EPS Break-Even Analysis

EBIT-EPS Break-Even Analysis -- Analysis -- Analysis of the effect of financing alternatives on

of the effect of financing alternatives on

earnings per share. The break-even point is

the EBIT level where EPS is the same for

two (or more) alternatives

two (or more) alternatives..

(EBITEBIT - I) (1 - t) - Pref. Div. # of Common Shares EPS

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EBIT-EPS Chart

 Current common equity shares = 50,000Current common equity shares = 50,000  $1 million in new financing of either:$1 million in new financing of either:

 All C.S. sold at $20/share (50,000 shares)  All debt with a coupon rate of 10%

 All P.S. with a dividend rate of 9%  Expected EBIT = $500,000Expected EBIT = $500,000

 Income tax rate is 30%Income tax rate is 30%

Basket Wonders

Basket Wonders has $2 million in LT financing has $2 million in LT financing (100% common stock equity).

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EBIT-EPS Calculation with

New Equity Financing

Common Stock Equity Alternative

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EBIT-EPS Calculation with

New Debt Financing

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EBIT-EPS Chart

between debtdebt and

common stock

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EBIT-EPS Calculation with

New Preferred Financing

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Degree of Financial

Leverage (DFL)

Degree of Financial Leverage

Degree of Financial Leverage -- The percentage change in a firm’s earnings

per share (EPS) resulting from a 1 percent change in operating profit.

=

Percentage change in earnings per share (EPS)

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Computing the DFL

EBIT = Earnings before interest and taxes= Earnings before interest and taxes I

I = Interest= Interest PD

PD = Preferred dividends= Preferred dividends t

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What is the DFL for Each

of the Financing Choices?

DFL

DFL_$500,000$500,000

Calculating the DFL for

Calculating the DFL for NEWNEW equity equity* alternativealternative

= $500,000$500,000 $500,000

$500,000 - 00 - [00 / (1 - 00)]

* The calculation is based on the expected EBIT

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What is the DFL for Each

of the Financing Choices?

DFL

DFL_$500,000$500,000

Calculating the DFL for NEWNEW debt debt * alternativealternative

= $500,000$500,000

{

{ $500,000 $500,000 - 100,000100,000

- [00 / (1 - 00)] }

= $500,000_$500,000 / $400,000 1.25

1.25

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What is the DFL for Each

of the Financing Choices?

DFL

DFL_$500,000$500,000

Calculating the DFL for NEWNEW preferred preferred * alternativealternative

= $500,000$500,000

{

{ $500,000 $500,000 - 0 0

- [90,00090,000 / (1 - .30.30)] }

= $500,000_$500,000 / $371,428 1.35

1.35

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Variability of EPS

 Preferred stock Preferred stock financing will lead to

the greatest variability in earnings per share based on the DFL.

 This is due to the tax deductibility of

interest on debt financing. DFL

DFL_Equity_Equity = 1.00 = 1.00

DFL

DFL_Debt_Debt = 1.25 = 1.25

DFL

DFL_Preferred_Preferred = = 1.351.35

Which financing method will have the greatest relative greatest relative

variability in EPS?

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Total Firm Risk

Total Firm Risk

Total Firm Risk -- The variability in earnings per -- The variability in earnings per share (EPS). It is the sum of business plus

share (EPS). It is the sum of business plus

financial risk.

financial risk. Total firm risk

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Degree of Total

Leverage (DTL)

Degree of Total Leverage

Degree of Total Leverage -- The

percentage change in a firm’s earnings per share (EPS) resulting from a 1

percent change in output (sales).

=

Percentage change in earnings per share (EPS)

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DTL Example

Lisa Miller wants to determine the Degree of Total Leverage

Degree of Total Leverage at EBIT=$500,000.

EBIT=$500,000. As we did earlier, we will assume that:

 Fixed costs Fixed costs are $100,000$100,000

 Baskets are sold for $43.75$43.75 eacheach

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Computing the DTL

for All-Equity Financing

DTL

DTL S dollars of sales

= $500,000$500,000 + $100,000 $500,000

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Computing the DTL

for Debt Financing

DTL

DTL S dollars of sales

= $500,000$500,000 + $100,000 { $500,000 $500,000 - $100,000$100,000

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Risk versus Return

Compare the expected EPS to the DTL for the common stock equity financing

approach to the debt financing approach. FinancingFinancing E(EPS)E(EPS) DTLDTL

EquityEquity $3.50$3.50 1.201.20

DebtDebt $5.60$5.60 1.501.50

Greater expected return (higher EPS) comes at

the expense of greater potential risk (higher DTL)!