Leverage

 Business vs. financial risk

 Operating leverage
 Financial Leverage

13-1
 What is business risk?
 Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Probability Low risk

High risk

0 E(EBIT) EBIT
 Note that business risk does not include financing
effects.
13-2
What determines business risk?
 Uncertainty about demand (sales).
 Uncertainty about output prices.
 Uncertainty about costs.
 Product, other types of liability.
 Operating leverage.

13-3
What is operating leverage, and how
does it affect a firm’s business risk?
 Operating leverage is the use of
fixed costs rather than variable
costs.
 If most costs are fixed, hence do not
decline when demand falls, then the
firm has high operating leverage.

13-4
 Effect of operating leverage
 More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
 What happens if variable costs change?
13-5
 Operating Leverage
 Operating leverage
affects a firm’s operating
profit (EBIT).
 The degree of
operating leverage % Change in EBIT
DOL 
(DOL) is defined as the % Change in Sales
percentage change in  EBIT/EBIT
DOL 
the earnings before  Sales/Sales
interest and taxes
relative to a given
percentage change in
sales.

13-6
 Using operating leverage

Low operating leverage

Probability
High operating leverage

EBITL EBITH

 Typical situation: Can use operating leverage

to get higher E(EBIT), but risk also increases.
13-7
What is financial leverage?
Financial risk?
 Financial leverage is the use of debt
and preferred stock.
 Financial risk is the additional risk
concentrated on common
stockholders as a result of financial
leverage.

13-8
Meaning of Financial Leverage
 The use of the fixed-charges sources of funds, such as
debt and preference capital along with the owners’
equity in the capital structure, is described as financial
leverage or gearing or trading on equity.
 The financial leverage employed by a company is
intended to earn more return on the fixed-charge funds
than their costs. The surplus (or deficit) will increase
(or decrease) the return on the owners’ equity. The
rate of return on the owners’ equity is levered above or
below the rate of return on total assets.

13-9
Measures of Financial
Leverage
 Debt ratio
 Debt–equity ratio
 Interest coverage
 The first two measures of financial leverage can
be expressed either in terms of book values or
market values. These two measures are also
known as measures of capital gearing.
 The third measure of financial leverage,
commonly known as coverage ratio. The
reciprocal of interest coverage is a measure of
the firm’s income gearing.
13-10
Financial Leverage and the
Shareholders’ Return
 The primary motive of a company in using financial
leverage is to magnify the shareholders’ return
under favourable economic conditions. The role of
financial leverage in magnifying the return of the
shareholders’ is based on the assumptions that the
fixed-charges funds (such as the loan from
financial institutions and banks or debentures) can
be obtained at a cost lower than the firm’s rate of
return on net assets (RONA or ROI).
 EPS, ROE and ROI are the important figures for
analysing the impact of financial leverage.
13-11
EPS and ROE Calculations
Profit after tax
Earnings per share =
Number of shares
PAT (EBIT  INT)(1  T )
EPS = 
N N

Profit after tax

Return on equity =
Value of equity
(EBIT  INT)(1  T )
ROE =
S

 For calculating ROE either the book value or the

market value equity may be used.

13-12
 A new firm XYZ ltd has been formed . The
management is expecting 24% return on
total investment of Rs 5,00,000
 This implies EBIT of Rs 120,000

13-13
 Effect of Financial Plan on EPS and
ROE: Constant EBIT
Financial Plan

Equity Debt-E
 The firm is considering
two alternative 1. Earnings before interest 120,000 120,000
financial plans: and taxes, EBIT

 (i) either to raise the 2. Less: interest, INT 0 37,500

entire funds by issuing 3. Profit before taxes, PBT = 120,000 82,500

50,000 ordinary shares at EBIT – INT

Rs 10 per share, or 4. Less: Taxes, T (EBIT –

INT)
60,000 41,250

 (ii) to raise Rs 250,000

5. Profit after taxes, PAT = 60,000 41,250
by issuing 25,000 (EBIT – INT) (1 – T)
ordinary shares at Rs 10 6. Total earnings of investors, 60,000 78,750
per share and borrow Rs PAT + INT
250,000 at 15 per cent 7. Number of ordinary shares, 50,000 25,000
rate of interest. N
8. EPS = (EBIT – INT) (1 – 1.20 1.65
 The tax rate is 50 per cent. T)/N
9. ROE = (EBIT – INT) (1 – 12.0% 16.5%
T)/S
13-14
Effect of Leverage on ROE
and EPS
EPS is greater under the debt equity
plan
•The firm is able to borrow at a lower
rate
•Reduction in number of equity in Debt-
E plan

13-15
 Interest Tax Shield
 Interest tax shield = Tax rate x Interest

 Just like depreciation tax shield

If the debt component is increased 75% debt,25% equity,

EPS = 0.45 roe 1.5%

13-16
 Leverage
Favorable ROI > I
Unfavorable ROI <I
Neutral ROI = I
ROE = {(r A-id) (1-T)} /E
= [{r (E+D) – id} (1-T)] / E
= [ r + (r-i) D/E](1-T)

13-17
Business risk vs. Financial risk
 Business risk depends on business
factors such as competition, product
liability, and operating leverage.
 Financial risk depends only on the
types of securities issued.
 More debt, more financial risk.
 Concentrates business risk on
stockholders.

13-18
An example:
Illustrating effects of financial leverage
 Two firms with the same operating leverage,
business risk, and probability distribution of
EBIT.
 Only differ with respect to their use of debt
(capital structure).

Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
13-19
 Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400

13-20
 Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680

*Same as for Firm U.

13-21
Ratio comparison between
leveraged and unleveraged firms
FIRM U Bad Avg Good
BEP 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%
TIE ∞ ∞ ∞

FIRM L Bad Avg Good

BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.50x 3.30x
13-22
Risk and return for leveraged
and unleveraged firms
Expected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x

Risk Measures:
Firm U Firm L
σROE 2.12% 4.24%
CVROE 0.24 0.39
13-23
The effect of leverage on
profitability and debt coverage
 For leverage to raise expected ROE, must
have BEP > kd.
 Why? If kd > BEP, then the interest expense
will be higher than the operating income
produced by debt-financed assets, so
leverage will depress income.
 As debt increases, TIE decreases because
EBIT is unaffected by debt, and interest
expense increases (Int Exp = kdD).
13-24
Conclusions
 Basic earning power (BEP) is
unaffected by financial leverage.
 L has higher expected ROE because
BEP > kd.
 L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk.

13-25
EBIT – EPS Analysis

.05 .10 .15 .35 .30 .05

Sales 510 660 710 800 880 1160
Cost
Variable 255 330 355 400 440 580
Fixed 280 280 280 280 280 280
Total 535 610 635 680 720 860
EBIT -25 50 75 120 160 300
ROI -5% 10% 15% 24% 32% 60%
13-26
 0 25% 50% 75%

EBIT EPS

-25 -.25 -.58 -1.25 -3.25

50 .50 .42 .25 -.25

75 .75 .75 .75 .75

120 1.20 1.35 1.65 2.55

160 1.6 1.88 2.45 4.15

300 3.00 3.75 5.25 9.75

13-27
EBIT – EPS Chart

EPS

EBIT

13-28
Calculation of Indifferent
Points
 Ordinary share capital of 10 lakh or 15% Deb
of 5 la and 5 la eq
 Ordinary share of 10n l or 13% pref of 5 and
eq 5
 13% pref cap of 2 and 15% deb of 3 la,eq of
5
 6 eq+ 15 % deb of 4 ,13% pref 2 + 4 la eq+
4 lac deb
Assume tax rate to be 50% and price of share
10 rs

13-29
Combining Financial and
Operating Leverages
 Operating leverage affects a firm’s
operating profit (EBIT), while financial
leverage affects profit after tax or the
earnings per share.
 The degrees of operating and
financial leverages is combined to
see the effect of total leverage on
EPS associated with a given
change in sales.

13-30
Combining Financial and
Operating Leverages
 The degree of combined leverage
(DCL) is given by the following equation:
% Change in EBIT % Change in EPS % Change in EPS
  
% Change in Sales % Change in EBIT % Change in Sales

 another way of expressing the degree of

combined leverage is as follows:
Q( s  v) Q( s  v)  F Q( s  v)
DCL   
Q(s  v)  F Q(s  v)  F  INT Q(s  v)  F  INT
13-31