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Reading 37 Measures of Leverage

37.1 Leverage
Leverage increases the volatility of a companys earnings and cash flows and increases the risk of
lending to or owning a company
Valuation of a company and its equity is affected by the degree of leverage the greater the leverage,
the greater its risk and so the greater the discount rate applied
Risk associated with future earnings and cash flows of a company are affected by the companys cost
structure
Cost structure is the mix of variable and fixed costs
If a company has higher fixed operating and financing costs, it has more leverage. We can see this
effect when we plot the net income of each company against the number of units produced and sold
greater slope of line representing net income (as number of units sold changes results in greater
change in net income)
Companies with more fixed costs relative to variable costs in their cost structures have greater
variation in net income as revenues fluctuate and hence, more risk

37.2 Business Risk and Financial Risk


37.2.1 Business Risk and its Components
Business risk risk associated with operating earnings (combination of sales risk and operating risk)
Operating risk risk attributed to the operating cost structure (use of fixed costs in operations)
The greater the fixed operating costs relative to variable operating costs, the greater the operating risk

37.2.2 Operating Risk


The greater the fixed component of costs, the more difficult it is for a company to adjust its operating
costs to change in sales
The greater the fixed operating costs relative to variable operating costs, the greater the operating risk
Elasticity a measure of sensitivity of changes in one item to changes in another
Operating income elasticity (Degree of Operating Leverage) measures how sensitive a companys
operating income is to changes in demand
Degree of operating leverage ratio of the percentage change in operating income to the percentage
change in units sold

=

Operating income revenue minus total operating costs (variable and fixed cost)

= [( ) (#)] [( ) (#)] [( )]

Per unit contribution margin the amount that each unit sold contributed to covering fixed costs
(difference between the price per unit and the variable cost per unit)
Contribution margin per unit contribution margin multiplied by quantity sold (revenue minus
variable cost)
Degree of operating leverage
[( )]
=
[( ) ]
DOL undefined when operating income is $0 because denominator is $0

Example 1 Calculating the DOL


Arnaud Kenigswald is analysing the potential impact of an improving economy on earnings at Global Auto,
one of the worlds largest car manufacturers. Global is headquartered in Berlin. Two Global Auto
divisions manufacture passenger cars and produce combined revenues of 93 billion. Kenigswald projects
that sales will improve by 10% due to increased demand for cars. He wants to see how Globals earnings
might respond given that level of increase in sales. He first looks at the degree of leverage at Global,
starting with operating leverage.
Global sold 6 million passenger cars in 2009. The average price per car was 24,000, fixed costs associated
with passenger car production total 15 billion per year, and variable costs per car are 14,000. What is
the degree of operating leverage of Global Auto?

Solution:
[6,000,000 (24,000 14,000)]
= = 1.33
[6,000,000 (24,000 14,000) 15,000,000,000]
For a 10% increase in cars sold, operating income increases by 1.33X10% = 13.33%

Industries (software developers & pharmaceutical) that tend to have high operating leverage are those
that invest upfront to produce a product but spend relatively little on making and distributing it

37.3 Financial Risk


Financial risk risk associated with how a company finances its operations
If a company finances with debt, it is legally obligated to pay the amounts that make up its debts
Debt and long term leases increases companies financial risk
If a company finances its business with common equity, generated either from operations (retained
earnings) or from issuing new common shares, it does not incur fixed obligations
Degree of financial leverage (DFL):
%
=
%
Net income operating income less interest and taxes
Let C be fixed financial cost and t be tax rate, DFL can be written as:
[( ) ](1 ) [( ) ]
= =
[( ) ](1 ) [( ) ]

DFL is not affected by tax rate


The greater the use of financing sources that require fixed obligations (interest), the greater the
sensitivity of net income to changes in operating income

Example 2 Calculating the Degree of Financial Leverage


Global Auto also employs debt financing. If Global can borrow at 8%, the interest cost is $40 billion. What
is the degree of financial leverage of Global Auto if 6 million cars are produced and sold?

Solution:
At 6 million cars produced and sold, operating income = $45 billion
$45
= = 9.0
$45 $40
For every 1% change in operating income, net income changes 9% due to financial leverage