CHAPTER 4

MEASURES OF LEVERAGE
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1. INTRODUCTION
Leverage is the use of fixed costs in a companys cost structure.
- Operating leverage relates to the companys operating cost structure.
- Financial leverage relates to the companys capital structure.

Fixed
Costs

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Fixed
Costs

WHY WORRY ABOUT LEVERAGE?

1. A companys use of leverage affects its risk and return.
2. Operating leverage and financial leverage provide insight into a companys
business and its future.
3. Leverage helps us understand a companys future cash flows and the risk
associated with those cash flows and, hence, its valuation.

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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 Company
One
Two
Number of units produced and sold
Sales price per unit
Variable cost per unit
Fixed operating cost
Fixed financing expense
Debt
Equity
Total assets
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1,000
250
125
50,000
5,000

1,000
250
25
100,000
55,000

50,000
700,000
750,000

550,000
200,000
750,000
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WHAT DOES LEVERAGE DO EXACTLY?

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

Company Two

200,000
150,000
100,000
50,000
Net
Income

0
- 50,000
- 100,000
- 150,000

Number of Units Produced and Sold

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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.

Sales
Risk

Operatin
g Risk
Business
Risk

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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.

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DOL
The DOL is at Q units produced and sold:
(4-2)
where
Qis the number of units
Pis the price per unit
Vis the variable operating cost per unit and
Fis the fixed operating cost

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EXAMPLE: COMPANY ONE AND COMPANY TWO

COMPANY ONE

COMPANY TWO

1.800

1.667%
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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.

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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.

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EXAMPLE: COMPANY ONE AND COMPANY TWO

Com
pany
One
1.071%

Com
pany
Com
Two
pany
Two
1.786%

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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.

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EXAMPLE: RETURN ON EQUITY

Consider the example of Company One and Company Two:
100%
80%
60%
40%
20%
Return on Equity0%
-20%
-40%
-60%
-80%

Company One

Company Two

Units Produced and Sold

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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.

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EXAMPLE: COMPANY ONE AND COMPANY TWO

Com
pany
One
1.786

Com
pany
Com
Two
pany
Two
3.214

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BREAKEVEN QUANTITY
The breakeven point (QBE) is the level of units produced and sold at which the
costs (both variable and fixed) are just coveredthat 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.

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EXAMPLE: COMPANY ONE AND COMPANY TWO

Com
pany
One

Operating b = 400 units

Com
pany
Com
Two
pany
Two

Operating b = 444 units

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RISKS TO CREDITORS AND OWNERS

Business risk is affected by demand uncertainty, output price uncertainty, and
cost uncertainty.
Financial risk adds to the companys 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.

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4. SUMMARY
Leverage is the use of fixed costs in a companys 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).

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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 companys net income is zero.
The operating breakeven point, QOBE, is the number of units produced and sold
at which the companys operating income is zero.

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