Definition of Leverage
A firms use of assets and liabilities having a fixed cost in an attempt to increase potential returns to the shareholder
In regard to ‘leverage’ what does the term ‘double edged sword’ mean?
Leverage increases the return on equity
Its also increae the risk
Definition of Operating Leverage
Arises from using assets having fixed operating cost (depreciation), excludes interest
Definition of Financial Leverage
Arises from using liabilities (preferred stock) and fixed costs (interest)
Operating Costs include..
Costs of good sod, selling, general and admin expense
Financial Costs include…
Interest expense and preferred stock dividends
Short Run costs include (3)…
1. Variable Costs
2. Fixed Costs
3. Semi-variable Costs
– If you produce over a certain threshold it will increase substantially
Long run costs include…
Purely variable cost. Nothing is fixed because when the firm grows you will need to buy additional facilities and increase more staff
How changes in sales influence EBIT is referred to as
Operating leverage refers to…
the employment of assets with fixed operating costs in an attempt to increase operating income (EBIT)
In regard to DOL what is the ‘Multipler Effect’?
By using assets with a fixed operating cost, a small change in sales is magnified to a larger change in EBIT
The degree in operating leverage refers to?
Measured as percentage change in EBIT resulting from a given percentage change in sales
What is the formula to calculate DOL
(Sales- VC)/ EBIT
DOL can stand for…
The number of units of $ amount
What is the interpretation is DOL=4
This means if sales increased by 1% EBIT would increase by 4% (1×4=4%)
When is the DOL largest?
At the breakeven point
When is DOL negative?
When you are below break even point
All other things being equal, the higher the firm’s DOL the greater is..
Business risk (the variability of a firm’s EBIT)
How a change in EBIT influences EPS is referred to as…
Financial leverage refers to?
The employment of funds having fixed capital costs in an attempt to increase EPS
In regard to DFL what is the ‘Multipler Effect?’
By using liabilities ( and prefered stock) having fixed costs, a small change in EBIT is magnified into a larger change in ESP
The degree in Financial Leverage refers to?
Measured as the percentage change resulting from a given percentage change in EBIT
What is the interpretation is DFL=4
A If EBIT increased by 10%, EPS would increase by (3 x 10%)= 30%
What is the formula to calculate DFL?
= EBIT/ EBIT- I – (Dp/1-T)
The DFL approaches its maximum value when…
When the firm comes closer to operating at loss (EPS= $0)
All other things being equal the higher the firm’s DFL, the greater its…
financial risk (The variability of a firms EPS that results from the use of financial leverage
In regard to ‘DFL’ what are preference dividends inflated to a before tax basis?
In order to be consistent, because we are using interest before tax, therefore we need to convert the dividend which is an after tax basis, to a pre tax basis
How a sale in sales effects the EPS is referred to as…
What is Combined Leverage?
Is the responsiveness of a firm’s net income (ESP/EBIT) to changes in sales
Combined leverage is the combination of…
‘Operating Leverage + Financial Leverage’
In regard to DCL what is the ‘Multiplier Effect’?
A small change in sales is magnified to larger change in EPS
What is the degree of combined leverage?
Measured as a percentage change in ESP, resulting from a given percentage change in sales
What is the formula to calculate DCL? (two ways)
= DOL X DFL
= (Sales – VC) / [EBIT – I – (Dp/1-T)]
What is the interpretation is DCL= 6?
A 10% increase in sales, would result in a ESP change of (6×10%) 60%
A firm with a high DOL, may choose a capital structure with ______ to avoid a _______
a low DFL, to avoid a high DCL
A firm can trade off ______ & ________ to control DCL
Operating and Financial
How is DCL related to DOL and DFL?
DCL= DOL x DFL
The relationship shows that operating and financial leverage can be combined in may different ways to achieve a given degree of combined leverage
Is is possible for a firm to have high degree of combined leverage and a low level of total risk?
Yes, if a firm has stable sales revenue and stable operating costs over time, the total risk of the firm will be low. The degree of combined leverage relates to changes in EPS to changes in sales revenue
Why are firms limited in the amount of Combined leverage used that can be used in seeking to increase ESP and shareholder wealth?
Because excessive use of financial leverage causes the market value of the firm to decline
Why does excessive you of financial leverage cause the market value of the firm to decline?
Because it increase the risk of financial destress, in with the costs of debt, preference shares and equity increase. This offsets the returns gained from using financial/ combined leverage
What is the EBIT-ESP Analysis
Aim to identify the financing mix (debt and equity) to maximise EPS for a particular range of EBIT
(determines when it is advantageous to use debt or equity)
What are the two financial leverage effects that occur, when a firm finances a project using debt?
1) Added variability in EPS
(This can be calculated by the use of DFL)
2) Level of EPS at a given EBIT under a
What is the EBIT-EPS ‘Indifference Point’? (two definitions)
Regardless of whether debt or equity is used, the EPS will be the same
EBIT levels at which earnings per share for both alternatives are equal
What is the format to work out EPS, share price and the EBIT indifference point?
= Net Income
/ # of shares = (share value/ share price)
x P/e (market price per share / earnings per share)
= Share Price
How do you calculate share price?
Share Price = EPS x (P/ E)
(market value/N)= (EAC/N) x (Market value/ EAC)
In regard to the EBIT-EPS analysis if risk increases the firm value should..
In regard to the EBIT-EPS analysis , the higher the leverage the _____ the P/E ratio
In regard to the EBIT-EPS analysis, the higher a firm’s financial risk the _______ the P/E ratio
What are the five ‘Other Factors to Consider in Making Capital Structure Decisions’?
1. Industry Standards
2. Profitability and Needs for Funds
3. Lender and Bond Rate Requirements
4. Managerial Risk Adverision
5. Retention of Control
In regards to ‘Other Factors to Consider in Making Capital Structure Decisions’? What does the term ‘Industry standards’ mean?
Comparison of financial risk, interest and fixed term coverage ratios (Debt ratios) against the industry standard
(However debt to capital ratio depends on the business risk, can you afford to take on more debt)
‘Other Factors to Consider in Making Capital Structure Decisions’? What does the term ‘Profitability and Need for Funds mean?
* Some companies will be more profitable and don’t need additional funding
* They will have lower debt ratios compared to companies who are less profitable
‘Other Factors to Consider in Making Capital Structure Decisions’? what does the term ‘Leverage But Out’ refer to?
Group of investors will take over the business. Because they have little little capital, they will have to borrow a high amount of debt and use assets as collateral
‘Other Factors to Consider in Making Capital Structure Decisions’? What does the term ‘Lender and Bond Rater Requirements’ refer to?
Lenders impose restrictions on a firm’s capital structure choices, as a condition for extending credit or maintaining a bond or preference share rating
Important guidelines, that a firm must follow if it wishes to improve its credit rating
‘Other Factors to Consider in Making Capital Structure Decisions’? What does the term ‘Managerial Risk Aversion’ refer to?
Some managers prefer unusually high or low risk. Therefore they will not have an optimal capital structure (WACC won’t be at its minimum)
‘Other Factors to Consider in Making Capital Structure Decisions’? What does the term ‘Retention of Control’ refer to?
The owners want to maintain control by issuing debt, instead of issuing ordinary shares. Because debt holders don’t have voting rights unlike shareholders
Under what circumstances should a firm use more debt in its capital structure than used by the “average firm in the industry”?
A firm will more debt if it is less profitable (therefore can’t use retained earnings to fund projects), or if its operating income (EBIT) is less stable
(This answer assumes that the average is operating near an optimal capital structure