Chapter 11.Measures of Leverage

Measures of Leverage

Section 1An Introduction to Leverage

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An Illustration of Unsystematic Risk

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What is Leverage? Leverage is usage of fixed coststo increase company’s profitability;

Fixed costs that are financial costs creates financial leverage;

Fixed costs that are operational costs create operational leverage;

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The Effect of Leverage on Company Earnings

Leverage can magnify earnings both up and down;

a. the profits of highly leveraged companies by surge in case of even small upturns in revenue;

a. on the contrary profits may suffer from losses as a result of small downturns in revenue;

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The Importance of Leverage

Company’s use of leverage needs attention for following reasons;

a. it’s an integral part of risk-return assessments. High level of increases the volatility of earnings and makes company riskier for lenders and shareholders ;

b. valuation of company requires forecasting of future cash flows and risk associated to this cash flows;

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Description of Leverage EffectExample

Consider the following example of two companies which have the identical performance; Impulse Robotics Malvey AerospaceRevenue $1,000,000 $1,000,000 Operating Costs $700,000 $ 750,000 Operating Income $300,000 $ 350,000Financing Cost $100,000 $150,000Net Income $200,000 $200,000

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Now let’s examine the impact of cost structure on company earnings! Impulse Robotics Malvey AerospaceNumber of units 100,000 100,000 Sales price per unit $10 $10Variable cost per unit $2 $ 6Fixed Operating Cost $500,000 $150,000Fixed Financing Expense $100,000 $50,000 Obviously Impulse Robotics has a higher proportion of fixed costs in it’s cost structure. So, it’s exposure to sales risk will be greater

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Let’s restate the profit figure assuming that sales level is 50,000 units Impulse Robotics Malvey AerospaceRevenue $500,000 $500,000 Operating Costs $600,000 $450,000 Operating Loss/Income $100,000 $50,000Financing Cost $100,000 $50,000Net Loss $200,000 $0

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Let’s restate the profit figure assuming that sales level is now 200,000 units Impulse Robotics Malvey AerospaceRevenue $2000,000 $2000,000 Operating Costs $900,000 $1,350,000 Operating Income $1,100,000 $650,000Financing Cost $100,000 $50,000Net Income $1000,000 $600,000 The example clearly describes the degree of Impulse Robotics’s sensitivity to sales level fluctuations. This fact is compatible with high leverage figure.

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Section 2 Business Risk

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Business Risk and It’s Components

Business risk is typically related to company’s operating earnings;

Prices and quantity of sales are uncertain and may be subject to deviations;

This type of risk is referred as sales risk; Operating risk on the other hand roots from company’s cost structure.Proportion of fixed costs relative to variable costs is crucial in this respect;

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Operating Risk

Risk deriving from the mix of fixed and variable costs is referred as operating risk;

The greater the portion of fixed to variable costs the greater risk business will have;

The high amount fixed costs on the other hand makes it difficult for company to adjust it’s operating costs to their sales level;

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Measuring of Operating Leverage

Response of operating earning to different demand levels is gauged by DOL(degree of operating leverage);

In other words DOL is the measure of operating leverage;

DOL formula can be expressed as; DOL=contribution margin operating income

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Degree of Operating LeverageExample

Global Auto divisions manufacture passenger cars and produce the revenue of $93,000,000.It’s projected that sales will increase by 10% due to increased demand in cars.Global sold 6,000,000 passenger cars in 2009.The average price per car was $24,000 and fixed costs associated with car production is total of $15,000,000 per year and variable costs per car are $14,000.Find the DOL for Global Auto.

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SolutionDOL= 6000,000(24,000-14,000)______ = 1.33

6000,000(24000-14000)-15,000,000

Breakeven Analysis Short-term decision making tool;

Sometimes referred as CVP(cost-volume-profit)analysis;

Attempts to find activity level which turns profit to zero;

Mathematically expressed as Breakeven in units= Fixed Costs___ Price-Variable Cost

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Break-Even CalculationExample

Let’s revisit Impulse Robotics and Malvey Aerospace example;

Breakeven Impulse Robotics= 500,000+100,000=75,000 units 10-2Breakeven Malvey Aerospace=150,000+50,000=50,000 units 10-6 The numbers tell that Impulse Robotics must sell 75,000 units in order to earn zero net profit. Additionally it turns out that to be profitable the company should sell more units in compared to Malvey Aerospace(because it has higher operating leverage)

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Operating Breakeven Point Breakeven point can also be specified in terms of

operating income; In this case fixed finance costs must be excluded;

Breakeven Impulse Robotics= 500,000=62,500 units 10-2Breakeven Malvey Aerospace=150,000=37,500 units 10-6 The first figure means that if Impulse Robotics sells 62 500 units

of product it’s operating profit will be equal to zero.

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Limitations of Break-Even Analysis

Costs are classified either fixed or variables costs however in the long run this distinction is not valid;

Assumes that changes in activity is the only factor that affect cost;

All units produced cannot be actually sold;

Don’t take account sales price fluctuations;

Is only applicable when only one type of product is sold or if there multiple products that are sold in constant mix;

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Section 3 Financial Risk

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Definition of Financial Risk Financial risk is the risk associated by how company finances it’s operations;

If debt is chosen as financing option then company will be subject to financing risk;

On the contrary if equity is the only financing source for company then any fixed obligation is unlikely to arise;

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Measuring of Financial Leverage

DFL(degree of financial leverage) looks the sensitivity of cash flows available to owners when operating income changes;

Using more debt financing increases the volatility of net income to changes in operating income;

DFL formula can be presented as DFL= Operating Income Operating Income-Finance Cost

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Financial LeverageExample

Let’s illustrate the effect of debt level on DFLIf operating income is $300,000 and fixed financing costs are $100,000 the degree of financial leverage isDFL= 300 000_______=1.5 300,000-100,000Now consider that fixed financing cost is $150,000.DFL=300 000_______=2 300,000-150,000Based on the results it can be concluded that the greater usege of debt as financing tool increases the sensitivity of net income to changes in operating income

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The Leveraging Role of DebtExample

Consider the Capital Company which is expected to generate $1 500,000 in revenues and $500,000 in operating earnings next year. Currently Capital Company doesn’t use debt financing and has assets of $2000,000.Suppose company were to change it’s capital structure buying back $1000,000 of shares and issuing $1000,000 of debt. If we assume that interest on debt is 5% and tax rate is 30% what is the effect of debt financing on company’s net income and ROE figure? Please note that operating earning may deviate in an amount of 40percent.

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The Leveraging Role of DebtExample

No Debt Expected Earnings Expected Earnings Expected Earnings +40% -40%EBIT $300,000 $500,000 $700,000Taxes $90,000 $150,000 $210,000 Net Income $210,000 $350,000 $490,000ROE 10.5% 17.5% 24.5%New Expected Earnings Expected Earnings Expected EarningsStructure +40% -40%EBIT $300,000 $500,000 $700,000Interest Expense $50,000 $50,000 $50,000EBT $250,000 $450,000 $650,000Taxes $75,000 $135,000 $195,000 Net Income $175,000 $315,000 $455,000ROE 17.5% 31.5% 45.5% 25

Final Words on Financial Leverage

Unlike operating leverage degree of financial leverage is more controllable by company management;

Typically companies operating in the same industry have the similar level of operating level, hence the similar cost structure;

On the other hand companies with high ratios of tangible assets to total assets are more inclined to have higher level of financial leverage;

One reason of this tendency is lenders feel more confident when they supply fund for companies having more tangible assets;these assets can be treated as collateral;

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Thank You

Economy & Finance

Chapter 11.Measures of Leverage