Fin man 6 financial leverage

F inanc ia l Management

Te a c h i n g S e r i e sJimmi Sinton

…………………………………………………………………

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Class #6

LEVERAGE ANALYSIS

T e a c h i n g S e r i e sJ i m m i S i n t o n Fi n a n c i a l M a n a g e m e n t

6-14 Financial Leverage

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Topics Materials Covered

pengertian dan jenis leverage

leverage operasi: pengertian, menentukan

tingkat DOL, analisa BEP dalam mempelajari

leverage operasi

leverage keuangan

hubungan leverage keuangan dengan

operasi

menentukan tingkat leverage keuangan

(DFL)

menentukan tingkat leverage kombinasi

(DCL)

indifference point antara hutang dan saham

biasa

………………

Please read each material before class and rehearse it after class

LEVERAGE KEUANGAN



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Leverage AnalysisLeverage AnalysisLeverage AnalysisIn 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

FULCRUM

% ∆

Sale

s

% ∆

Sale

s

% ∆

Sale

s

% ∆ Profits

Financial Leverag

e



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Types of RiskThere 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 in the firm’s EBT. This type of risk is a direct result of management decisions regarding the relative amounts of debt and equity in the capital structure

Leverage AnalysisLeverage Analysis



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OperatingLeverage



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The Degree of Operating Leverage - DOLThe 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

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

Leverage Analysis - Operating LeverageLeverage Analysis - Operating Leverage



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OPERATING LEVERAGEWhat is it? How is it Increased?

Operating leverage is:The increased volatility in operating income caused by fixed operating costs.

Managers do make decisions affecting the cost structure of the firm.

Managers can decide to invest in assets that give rise to additional fixed costs in intention to reduce variable costs.Commonly accomplished by a firm choosing to become more capital intensive and less labour intensive, thereby increasing operating leverage.




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Operating LeverageAdvantages and DisadvantagesAdvantages:

Magnification of profits to the shareholders if the firm is profitable.Operating efficiencies (faster production, fewer errors, higher quality) usually result increasing productivity, reducing ‘downtime’ etc.Disadvantages:Magnification of losses to the shareholders if the firm is not profitable.Higher break even pointHigh capital cost of equipment and the illiquidity of such an investment make it:Expensive (more difficult to finance)Potentially exposed to technological obsolescence, etc.




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Calculating the DOLThe degree of operating leverage can be calculated as:

DOLEBIT

Sales%

%

DOL with One income

statement:

DOLQ p v

Q p v FC

Sales VC

EBIT


DOL with Two income

statement:



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FinancialLeverage



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Capital StructureThe mix of debt, preferred stock, and common stock the firm plans to use over the long-run to finance its operationsThe proportions should be set in such a way as to balance risk/return and thereby maximize the price of the stock



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FINANCIAL LEVERAGEWhat is it? How is it Increased?

Your textbook defines financial leverage as:The increased volatility in operating income caused by the corporate use of sources of capital that carry fixed financial costs.

Financial leverage can be increased in the firm by:Selling bonds or preferred stock (taking on financial obligations with fixed annual claims on cash flow)Using the the debt to retire equity

Leverage AnalysisLeverage Analysis



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Leverage Analysis – Financial LeverageLeverage Analysis – Financial LeverageFinancial LeverageAdvantages and Disadvantages

Advantages:Magnification of profits to the shareholders if the firm is profitable.Lowering cost of capital to moderate levels of financial leverage, because interest expense is tax-deductible.

Disadvantages:Magnification of losses to the shareholders if the firm is not profitable.Higher break even point.At higher levels of financial leverage, the low after-tax cost of debt is offset by other effects such as:Present value of the rising probability of bankruptcy costsAgency costsLower operating income (EBIT), etc.



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The Degree of Financial Leverage (DFL)

Leverage Analysis Wolverine Corporation ($000) Leverage Scenarios 1 2 3

0%

Debt

50% Debt

80% Debt

Capital

Debt $

-

$ 500

$

800

Equity 1,000 500 200

Total $

1,000

$ 1,000

$

1,000

Shares @ $10 100,000 50,000 20,000

Revenue $

1,000

$ 1,000

$

1,000

Cost/expense 800 800 800

EBIT $

200

$ 200

$

200

Interest (10%) 0 50 80

EBT $

200

$ 150

$

120

Tax (40%) 80 60 48

EAT $

120

$ 90

$

72

ROE 12% 18% 36%

EPS $ 1.20

$ 1.80

$ 3.60

As the firm’s debt ratio rises, both EPS and

ROE rise dramatically.

While EAT falls, the number of

shares outstanding falls at a faster rate

as debt replaces equity.

GOOD SIDE of debt

Leverage Analysis – Financial LeverageLeverage Analysis – Financial Leverage



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The Degree of Financial Leverage (DFL)

BAD SIDE of debt

Leverage Analysis Wolverine Corporation ($000) Leverage Scenarios 1 2 3

0%

Debt

50% Debt

80% Debt

Capital

Debt $

-

$ 500

$

800

Equity 1,000 500 200

Total $

1,000

$ 1,000

$

1,000

Shares @ $10 100,000 50,000 20,000

Revenue $

800

$ 800

$

800

Cost/expense 720 720 720

EBIT $

80

$ 80

$

80

Interest (10%) 0 50 80

EBT $

80

$ 30

$

-

Tax (40%) 32 12 0

EAT $

48

$ 18

$

-

ROE 4.8% 3.6% 0%

EPS $ 0.48

$ 0.36

$

-

Wolfie is now doing rather poorly—ROE

are quite low. As the firm

adds leverage, EPS and ROE

decrease.




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The Degree of Financial Leverage (DFL)The DFL is a measure of the % changes in EBT that result from changes in EBIT, it is calculated as:

DFLEBT

EBIT%

%

DFL with One income

statement:

DFLEBIT

EBT

DFL with Two income

statement:




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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:

DCLEBT

Sales

EBIT

Sales

EBT

EBITDOL DFL

%

%

%

%

%

%

It is important to note that DCL is the product (not the sum) of both DOL and DFL




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Calculating Leverage Measures

Base Case Sales Down 10% Sales up 10%Sales 1000 900 1100Variable Costs 450 405 495Fixed Costs 300 300 300Depreciation 100 100 100EBIT 150 95 205Interest Expense 30 30 30EBT 120 65 175

Percentage Changes Relative to the Base CaseSales -10.000% 10.000%EBIT -36.667% 36.667%EBT -45.833% 45.833%

Leverage MeasuresUsing a single income statement:DOL 3.67 5.21 2.95DFL 1.25 1.46 1.17DCL 4.58 7.62 3.46

Using two income statements:DOL 3.67DFL 1.25DCL 4.58




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Comparing Operating and Financial LeverageFL and OL are similar in that both can enhance results while increasing variation

FL involves substituting debt for equity in the firm’s capital structure

OL involves substituting fixed costs for variable costs in the firm’s cost structure

Both substituting fixed cash outflows for variable cash outflows

Both kinds of leverage make their respective risks larger as the levels of leverage increaseHowever, financial risk is non-existent if debt is not present, while business risk would still exist even if no operating leverage existedFL is more controllable than OL




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Effects of Operating and Financial LeverageSummaryEquity holders bear the added risks associated with

the use of leverage.

The higher the use of leverage (either operating or financial) the higher the risk to the shareholder.

Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost of capital.


HIGHER LEVERAGE = HIGHER COST OF CAPITAL



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Indifference PointThe level of sales at which EPS will be the same whether the firm uses debt or equity or prefered

stock

The indifference point between any two financing methods can be expressed mathematically:

( EBIT*- I1) (1-T) (EBIT*- I2) (1-T)S1 S2

=

I1,I2= annual interest expenses or preferred dividends on a before tax

basis

S1,S2=number of common shares outstanding for methods 1 and 2.

T= tax rate



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30 100 200 300 400 500 600 700

EBIT ($ thousands)

Earn

ing

s p

er

Share

($

)

0

1

2

3

4

5

6

Common

Debt

Indifference pointbetween debt andcommon stockfinancing

Indifference Curve



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EXAMPLE 1:

A company with long-term capitalization of $ 10 million consisting entirely of common stock wishes to raise another $5 million for expansion through one of the two possible financing plans.The company may finance with

1.All common stock 2.All debt at 9%

EBIT is $ 1,400,000 and tax rate is 50%. 200,000 shares of stock are presently outstanding. Common stock can be sold at $ 50 per share.( 100,000 additional shares)In this example, the hypothetical level of EBIT is $ 2million.

All Common All Debt EBIT 2,000,000 2,000,000Interest 0 450,000Earnings before taxes 2,000,000 1,550,000Taxes 1,000,000 775,000Net Income 1,000,000 775,000Earnings available to Shareholders 1,000,000 775,000Number of shares 300,000 200,000Earnings per share $3.33 $3.88



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Indifference level of EBIT between debt and common stock financing:

( EBIT*- 0) (1-0.50)= (EBIT* –450,000) (1-0.50)

300,000 200,000

EBIT*(0.5) (200,000)= (EBIT (0.50)-450,000 (0.50))

300,000

100,000EBIT*=135,000,000

EBIT*= $ 1,350,000

The indifference point between debt and common alternatives is at $ 1,350,000. If EBIT is below this amount, common stock financing will give higher EPS. If EBIT is above this amount debt financing will provide higher EPS.