CHAPTER 4 MEASURES OF LEVERAGE Presenter’s name Presenter’s title dd Month yyyy

CHAPTER 4MEASURES OF LEVERAGEPresenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

1. INTRODUCTION

Leverage is the use of fixed costs in a company’s cost structure.

- Operating leverage relates to the company’s operating cost structure.

- Financial leverage relates to the company’s capital structure.

Fixed Costs Fixed

Costs


WHY WORRY ABOUT LEVERAGE?

1. A company’s use of leverage affects its risk and return.

2. Operating leverage and financial leverage provide insight into a company’s business and its future.

3. Leverage helps us understand a company’s future cash flows and the risk associated with those cash flows and, hence, its valuation.


2. LEVERAGE

• Leverage increases the volatility of earnings and cash flows → hence, it increases risk to suppliers of capital (creditors and owners).

• Consider two companies, Company One and Company Two, with the following information:

Company One

Company Two

Number of units produced and sold 1,000 1,000Sales price per unit €250 €250Variable cost per unit €125 €25Fixed operating cost €50,000 €100,000Fixed financing expense €5,000 €55,000

Debt €50,000 €550,000Equity €700,000 €200,000Total assets €750,000 €750,000


WHAT DOES LEVERAGE DO EXACTLY?

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

-€ 150,000

-€ 100,000

-€ 50,000

€ 0

€ 50,000

€ 100,000

€ 150,000

€ 200,000

Company One Company Two

Number of Units Produced and Sold

Net Income

Company Two uses more operating and financial leverage than Company One.


3. BUSINESS RISK AND FINANCIAL RISK

• Business risk is the risk associated with the volatility in operating earnings.

- Business risk is composed of both operating and sales risk.

• Sales risk is the uncertainty associated with the number of units produced and sold, as well as the sales price.

Business Risk

Sales Risk

Operating Risk


OPERATING RISK

• Operating risk is the risk associated with the mix of variable and fixed operating expenses.

- Operating risk is the sensitivity (i.e., elasticity) of operating earnings to changes in unit sales.

• The degree of operating leverage (DOL) is the ratio of the percentage change in operating income to the percentage change in units sold.

• The per unit contribution margin is the difference between the sales price and the variable cost per unit. This difference is available to cover fixed operating costs.

- Overall, for all units sold, the contribution margin is the difference between total revenues and variable operating costs.


DOL

The DOL is at Q units produced and sold:

(4-2)

where

Q is the number of units

P is the price per unit

V is the variable operating cost per unit and

F is the fixed operating cost


EXAMPLE: COMPANY ONE AND COMPANY TWO

COMPANY ONE

1.667%

COMPANY TWO

1.800


FINANCIAL RISK

• Financial risk is the risk associated with the choice of financing the business.

- The greater the reliance on fixed-cost obligations, such as debt, the greater the financial risk.

- Similar to operating risk, financial risk elasticity is the sensitivity of income available to owners to a change in operating earnings.

• The degree of financial leverage (DFL) is the ratio of the percentage change in net income to the percentage change in operating income.


DFL

At a specific level of operating earnings (and, therefore, Q):

(4-4)

where Q, P, V, and F are as before, and C is the fixed financial cost.


EXAMPLE: COMPANY ONE AND COMPANY TWOCompany One

1.071%

Company Two

1.786%


RETURN ON EQUITY AND THE DFL

• The greater the degree of financial leverage, the greater the financial risk.

• We can see the leveraging effect by looking at the return on equity (ROE) for different levels of units produced and sold.

• The greater the DFL, the more sensitive the ROE is to changes in the units produced and sold.


EXAMPLE: RETURN ON EQUITY

Consider the example of Company One and Company Two:

100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

1400

1500

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%Company One Company Two

Units Produced and Sold

Return on Equity


DEGREE OF TOTAL LEVERAGE

• Total leverage is the combined effect of operating leverage and financial leverage.

• The degree of total leverage (DTL) is the product of the degree of operating leverage and the degree of financial leverage:

(4-6)

Or, equivalently:

DTL = DOL × DTL

• If DOL is 3 and DFL is 2, DTL = 2 × 3 = 6.

- So, a 1% change in the units produced and sold results in a 6% change in the earnings to owners.


EXAMPLE: COMPANY ONE AND COMPANY TWOCompany One

1.786

Company Two

3.214


BREAKEVEN QUANTITY

• The breakeven point (QBE) is the level of units produced and sold at which the costs (both variable and fixed) are just covered—that is, net income is zero.

• The breakeven point is

(4-7)

• The operating breakeven point (QOBE) is the level of units produced and sold at which the operating costs are covered.


EXAMPLE: COMPANY ONE AND COMPANY TWOCompany One Operating b = 400 units

Company Two Operating b = 444 units


RISKS TO CREDITORS AND OWNERS

• Business risk is affected by demand uncertainty, output price uncertainty, and cost uncertainty.

• Financial risk adds to the company’s business risk, increasing the risk to creditors and owners.

• The creditor claims are fixed, whereas the equity claims are residual.

• In the event that creditor claims cannot be satisfied, there may be legal statuses that help sort out the claims:

- Reorganization is the restructuring of claims, with the expectation that the company will be able to continue, in some form, as a going concern.

- Liquidation is the situation in which assets are sold and then the proceeds distributed to claimants.


4. SUMMARY

• Leverage is the use of fixed costs in a company’s cost structure.

• Business risk is the risk associated with operating earnings and reflects

- sales risk (uncertainty with respect to the price and quantity of sales) and

- operating risk (the risk related to the use of fixed costs in operations).

• Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity and debt financing of the business).


SUMMARY (CONTINUED)

• The degree of operating leverage (DOL) is the sensitivity of operating earnings to changes in units produced and sold.

• The degree of financial leverage (DFL) is the sensitivity of cash flows to owners to changes in operating earnings.

• The degree of total leverage (DTL) is the sensitivity of the cash flows to owners to changes in unit sales.

• The breakeven point, QBE, is the number of units produced and sold at which the company’s net income is zero.

• The operating breakeven point, QOBE, is the number of units produced and sold at which the company’s operating income is zero.

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CHAPTER 4 MEASURES OF LEVERAGE Presenter’s name Presenter’s title dd Month yyyy