Lecture Note: Leverage & Long term sources of capital 2009

Chapter Five
Leverage and Long Term Sources of Capital
This chapter’s objectives are to enable you to:
Ø Describe and understand the concept of leverage
Ø Describe and illustrate the type of leverage
Ø Describe and understand the long term source of finance
5.1. The concept of Leverage
Leverage and capital structure are closely related concepts that are linked to cost of
capital and therefore capital budget decision. Leverage results from the use of fixed cost assets or
funds to magnify returns to the firm’s owners. Changes in leverage result in changes in level of
return and associated risk. Generally, increases in leverage result in increased return and risk,
whereas decreases in leverage result in decreased return and risk. The amount of leverage in the
firm’s capital structure – the mix of long-term debt and equity maintained by the firm- can
significantly affect its value by affecting return and risk. Unlike some causes of risk,
management has almost complete control over the risk introduced through the use of leverage.
The levels of fixed cost assets and funds that management selects affect the variability of returns,
that is, risk, which is therefore controllable by management. Because of its effect on value, the
financial manager must understand how to measure and evaluate leverage, particularly when
attempting to create the best capital structure.
The leverage concept is very general. It is not unique to business or finance, and it can be
used to analyze many different types of problems. For example, other disciplines, such as
economics and engineering, use the same concept and refer to it as elasticity. When used in a
financial setting, leverage measures the behavior of interrelated variables, such as output,
revenue, EBIT, and EPS
This chapter focuses on useful to the financial manager in his or her determination of the
firm’s proper financial structure. It includes the definitions of the different kinds of risk, a review
of break-even analysis, the concepts of operating, financial, and the combination of both
leverage, and their effect on EPS (earnings per share)
Risk has been defined as the likely variability associated with expected revenue streams.
Focusing on the financial decision, the variations in the income stream can be attributed to: (A)
the firm’s exposure to business risk. (B) the firm’s decision to incur financial risk.

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(A) Business risk can be defined as the variability of the firm’s expected earnings before
interest and taxes (EBIT). It is measures by the firm’s corresponding expected coefficient
of variation (i.e., the larger the ratio, the more risk a firm is exposed to). Dispersion in
operating income does not cause business risk. It is the result of several influences, for
example, the company’s cost structure, product demand characteristics, and intra-
industry competition. These influences are a direct of the firm’s investment decision.
(B) Financial risk is a direct result of the firm’s financing decision. When the firm is
selecting different financial alternatives, financial risk refers to the additional variability
in earnings available to the firm’s common shareholders and the additional chance of
insolvency borne by the common shareholder caused by the use o financial leverage.
Financial leverage is the financing of a portion of the firm’s assets with securities bearing
a fixed (limited) rate of return in hopes of increasing the ultimate return to the common
shareholders. Financial risk is to a large extent passed on to the common shareholders
who must bear almost all of the potential inconsistencies of returns to the firm after the
deduction of fixed payment.
Breakeven analysis, which is sometimes called cost-volume profit analysis, is
used by the firm (1) to determine the level of operations necessary to cover all operating
costs and (2) to evaluate the profitability associated with various levels of sales. The
firm’s operating breakeven point is the level of sales necessary to cover all operating
costs and financial costs. At the operating breakeven point, EBIT equals $0. the first step
in finding the operating breakeven point is to divide the cost of goods sold and operating
expenses into fixed and variable operating cost. Fixed costs are a function of time, not
sales volume, and are typically contractual; rent, depreciation, insurance premiums,
property taxes etc, for example is a fixed cost. Variable costs vary directly with sales and
are a function of volume, not time, shipping costs, direct labor, energy cost associated
with the production area, packaging, freight-out, sales commissions etc, for example, are
a variable cost.
The Algebraic Approach
Using the following variables, we can represent the operating portion of the firm’s income
statement,
P = Sales price per unit

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Q = Sales quantity in units

FC = Fixed operating cost per period
VC = Variable operating cost per unit
A formula for EBIT is written follows
EBIT = (P*Q) – FC –(VC*Q)
= Q * (P-VC) – FC
At the breakeven point EBIT is equal to 0, so Q = FC
P-VC
For Example (1):- Assume the selam distributors wishes to evaluate the impact of (1) increasing
fixed operating cost to birr 3,000, (2) increasing the sales price per unit to birr 12.50, (3)
increasing the variable operating cost per unit to birr 7.50, and (4) simultaneously implementing
all three of these changes.
Required: compute the operating breakeven point separately.
5.2. Type of Leverage
The three basic types of leverage can best be defined with reference to the firm’s income
statement. In the general income statement format below, the portions related to the firm’s
operating, financial, and total leverage are clearly labeled.
General Income Statement Format and Types of Leverage

Sales revenue
Operating Less CGS
Leverage Gross Profit Total
Less operating expenses Leverage
EBIT
Less Interest
Net profit before taxes
Financial Less Taxes
Leverage Net profit after taxes
Less Preferred stock dividends
Earning available for common stockholders
Earning per share (EPS)

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1. Operating leverage (OL) is concerned with the relationship b/n the firm’s sales revenue
and it’s EBIT. (EBIT is a descriptive label for operating profit). Operating leverage
results from the existence of fixed operating costs in the firm’s income stream. We can
define operating leverage as the potential use of fixed operating costs to magnify the
effects of changes in sales on the firm’s EBIT. Operating leverage occurs any time a firm
has fixed costs. In other words, with fixed operating costs, the percentage change in
profits accompanying a change in volume is greater than the percentage change in
volume.
For Example (2):- Assume the above data of selam distributors that is example -1- and compute
and analysis operating leverage.
Measuring the Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) is the numerical measure of the firm’s operating
leverage. It can be derived by using the following equation.
DOL = Percentage change in EBIT
Percentage change in Sales
The degree of operating leverage also depends on the base level of sales used as a point of
reference. The closer the base sales level used is to the operating breakeven point, the greater the
operating leverage. Comparison of the DOL of two firms is valid only when the base level of
sales used for each firm is the same
The direct formula to calculate degree of operating leverage at base level, Q is shown
below, using the symbol given earlier.
DOL at base sales level Q = Q * (P – VC)
Q * (P-VC)-FC
= Contribution Margin
EBIT
For Example (3):- Assume the above data of selam distributors that is example -1- and compute
and analysis the degree of operating leverage.
Fixed costs and operating leverage
Changes in fixed operating costs affect operating leverage significantly. Firms can sometimes
incur fixed operating costs rather than variable operating costs and at other times may be able to
substitute one type of cost for the other. For example, a firm could make fixed-dollar lease

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payments rather than payments equal to a specified percentage of sales, or it could compensate
sales representatives with a fixed salary and bonus rather than on a pure percent-of-sales
commission basis. The effects in fixed operating costs on operating leverage can best be
illustrated by continuing our example.
For Example (4):- Assume that Selam distributors is able to exchange a portion of its variable
operating costs 9by eliminating sales commission) for fixed operating costs (by increasing sales
salaries). This exchange results in a reduction in the variable operating cost per unit form birr 5
to birr 4.50 and an increase in the fixed operating costs from birr 2,500 to birr 3,000
Required: Compute and analysis the degree of operating leverage.
2. Financial Leverage (FL) is concerned with the relationship b/n the firm’s EBIT and its
common stock earnings per share (EPS). FL results from the presence of fixed financial
costs in the firm’s income stream. Financial leverage can be defined as potential use of
fixed financial costs to magnify the effect of changes in EBIT on the firm’s EPS. The two
financial costs that may be found in the firm’s income statement are interest on debt and
preferred stock dividends. These charges must be paid regardless of the amount of EBIT
available to pay them. Although preferred stock dividends can be “Passed” (not paid) at
the option of the firm’s directors, it is generally believed that the payment of such
dividends is necessary. Therefore the preferred stock dividends if it were contractual
obligations, not only to be paid as fixed amount, but also to be paid as scheduled.
Although failure to pay preferred dividends can not force the firm in to bankruptcy, it
increases the common stockholders’ risk b/c they cannot be paid dividends until the
claims of preferred stockholders are satisfied.
For Example (5):- The financial manager of XYZ company expects that its EBIT in the current
year would be birr 10,000. The firm has 5% bonds aggregating birr 40,000, while the 10%
preferred share amount to birr 20,000.
Required:
1. What would be the EPS at birr 10,000 EBIT?
2. Assuming the EBIT being case (2) birr 6,000 and case (1) birr 14,000, how would the
EPS be affected? The firm’s tax rate is 35% and there are 1000 common share
outstanding.

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Measuring the Degree OF Financial Leverage (DFL)

The DFL is the numerical measures of the firm’s financial leverage. DFL also called the
coefficient of FL is the percentage change in EPS (dependent variable) that results form a given
percentage change in EBIT (independent variable)
DFL = percentage change in EPS
Percentage change in EBIT
This approach is valid only when the base level of EBIT used to calculate and compare these
values is the same. In other words, the base level of EBIT must be held constant to compare the
financial leverage associated with different levels of fixed financial costs.
A more direct formula for calculating the DFL at a base level of EBIT, Note that in the
denominator, the term 1/(1-T) converts the after tax preferred stock dividend to a before tax
amount for consistency with the other terms in the equation.
DFL at base level EBIT= EBIT
EBIT –I- (PD*1/1-T)
Where: - PD is preferred stock dividend, I is annual interest on debt and T is tax rate
By using this formula for DFL, it is possible to get a negative value for the DFL if the EPS for
the base level of EBIT is negative. Rather than show absolute value signs in the equation, it is
instead assumed that the base-level EPS is positive.
For Example (6):- assume the above example-5- and compute and analysis the degree of
financial leverage.
3. Total Leverage (TL) is concerned with the relationship between the firm’s sales revenue
and earning per share (EPS). The combined effect of operating and financial leverage on
the firm’s risk can be assessed by using a framework similar to that used to develop the
individual concepts of leverage. This combined effect, or total leverage, can be defined as
the potential use of fixed costs, both operating and financial, to magnify the effect of
changes in sales on the firm’s earning per share (EPS). Total leverage can therefore be
viewed as the total impact of the fixed costs in the firm’s operating and financial
structure.
For Example (7):- Mosobo Cement Factory expected to sales of 30,000 and 45,000 units at
birr 10 per unit in the coming year and must meet the following variable operating cost birr 4
per unit, fixed operating cost birr 20,000, interest of birr 40,000 and preferred stock dividend

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birr 24,000 birr. The firm is in 40% tax rate and has 10,000 shares of common stock
outstanding.
Required: Analysis total leverage.
Measuring the Degree of Total Leverage (DTL)
The DTL is the numerical measure of the firm’s total leverage. It can be obtained in a fashion
similar to that used to measure operating and financial leverage.
DTL = Percentage change in EPS
Percentage change in sales
This approach is valid only when the base level of sales used to calculate and compare these
values is the same. In other words, the base level of sales must be held constant to compare the
total leverage associated with different levels of fixed costs.
For Example (8):- Assume the above example-7- and compute and analysis the degree of total
leverage
A more direct formula for calculating the DTL at a given base level of sales Q
DTL = Q * (P-VC)
Q * (P-VC) – FC – I – (PD * 1/1-T)
By using this formula for DTL, it is possible to get a negative value for the DTL if the EPS for
the base level of sales is negative. For our purposes, rather than show absolute value signs in the
equation, we instead assume that the base level EPS is positive.
The Relationship of Operating, Financial, and Total Leverage
Total leverage reflects the combined impact of operating and financial leverage on the firm. High
operating leverage and high financial leverage will cause total leverage to be high. The opposite
will also be true. The relationship among operating leverage and financial leverage is
multiplicative rather than additive. The relationship b/n the degree of total leverage and the
degrees of operating and financial leverage is given below:-
DTL = DOL * DFL
For Example (9):- Assume the above example -7- and compute and related the leverage system.
5.3. The concept of Long term sources of Finance
The long-term finance available to a company for raising capital are:
A. Equity capital (ordinary share equity and retained earnings)
B. preference share capital

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C. Long-term debt
1. Ordinary shares: - represent the ownership position in a company.
Features of Ordinary shares
A. Claim on Income
Ordinary shareholders have a residual ownership claim. They have a claim to the residual
income, which is earnings for ordinary shareholders, after paying expenses, interest charges,
taxes and preference dividends is paid. This income may be split into two parts: Dividend and
Retained earnings. Dividends are immediate cash flows to shareholders. Retained earnings are
reinvested in the business and shareholders stand to benefit in future in the form of the firm's
enhanced value and earning power and ultimately enhanced dividend and capital gain.
Dividends payable depend on the discretion of the company's broad of directors. A company is
not under a legal obligation to distribute dividend out of the available earnings. Capital gains
depend on the future market value of ordinary shares. Thus, an ordinary share is a risky security
from the investor's point of view. Dividends paid on ordinary shares are not tax deductible in
the hands of company.
B. Claim on assets
Ordinary shareholders also have a residual claim on the company's assets in the case of
liquidation. Out of the residual value of assets, first the claim of debt-holders and then preference
shareholders are satisfied, and remaining balance, if any is paid to ordinary shareholders.
C. Right to control
Control in the context of a company means the power to determine its policies, to appoint
directors (Management). The company's major policies and decision are approved by the board
of directors while day-to-day operations are carried out by managers appointed by the board.
Ordinary shareholders are able to control management of the company through their voting right
and right to maintain proportionate ownership.
D. Voting Rights
Ordinary shareholders are required to vote on a number of important matters; election of
directors and change in the memorandum of association.
E. Pre-emptive right
The pre-emptive right entitles a shareholders to maintain his proportionate share of
ownership in the company. The law grants shareholders the right to purchase new shares in the

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same proportion as their current ownership. Thus, if a shareholder owns 2% of the company's
ordinary shares, he/she has pre-emptive right to buy 2% of new shares issued.
F. Limited Liability
Ordinary shareholders are the true owners of the company, but their liability is limited to
the amount of their investment in shares. If a shareholders has already fully paid the issue price
of shares purchased, he has no thing more to contribute in the event of financial distress or
liquidation.
Pros and Loans of Equity Financing
A. Advantages
I. Permanent capital
Since ordinary shares are not redeemable, the company has no liability for cash outflow
associated with its redemption. It is a permanent capital, and is available for use as long as the
company goes.
II. Borrowing Base:
The equity capital increases the company's financial base, and thus its borrowing limit. Lenders
ger1.erally lend in proportion to company's equity capital. By issuing ordinary shares, the
company increases its financial capability. It can borrow when it needs additional funds.
III. Dividend payment discretion:
A company is not legally obligated to pay dividend. In times of financial difficulties, it can
reduce or suspend payment of dividend. Thus, it can avoid cash outflow associated with ordinary
shares
B. Disadvantages
I. Cost:
Shares have a higher cost at least for two reasons. Dividends are not tax deductible as are interest
payments, and flotation cost on ordinary shares are higher than those on debt.
II. Risk:
Ordinary shares are riskier from investors' point of view as there is uncertainty regarding
dividend and capital gains. Therefore they require a relatively higher rate of return. This makes
equity capital as a highest cost source of finance.
III. Earnings Dilution:

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The issue of new ordinary shares dilutes the existing shareholders' earnings per share if the
profits do not increase immediately in proportion to the increase in the number of ordinary
shares.
IV. Ownership dilution:
The issuance of new ordinary shares may dilute the ownership and control of the existing
shareholders.
2. Preferred Shares
A preference share is often considered to be a hybrid since it has 'many features of both ordinary
shares and debentures (Bonds). It is similar to ordinary shares in that:
A. The non-payment of dividend does not force the company to insolvency.
B. Dividends are not deductible for tax purpose, and
C. It has no fixed maturity date
On the other hand, it is similar to debentures (bonds) in that:
A. Dividend rate is fixed
B. Preference shareholders do not share in the residual earnings,
C. Preference shareholders have claims in income and assets prior to ordinary shareholders,
D. They usually do not have voting right.
Features of Preference shares
A. Claim on Income and assets:
A preference share is a senior security as compared to ordinary share. It has prior claim
on the company's income in the sense that the company must first pay preference dividends
before paying ordinary dividend. It has prior claim on asset in the event of liquidation. The
preference share claim is honored after that of a debenture and before that of ordinary shares.
Thus, in terms of risk, preference share is less riskly than ordinary shares, but more risky than
debentures.
B. Fixed dividend:
The dividend rate is fixed in case of preference shares and preference dividends are not
tax deductible. Preference share is called fixed income security because it provides a constant
income to investors. The payment of preference dividend is not a legal obligation.
C. Cumulative Dividends:

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Preference shares may carry a cumulative dividend feature, requiring that all past unpaid
preference dividends be paid before any ordinary dividends are paid. This feature is a protective
device for preference shareholders. Preference shareholders do not have power to force the
company to pay dividends; non-payment of preference dividend also does not result into
insolvency. Since preference share does not have the... dividend enforcement power, the
cumulative feature is necessary to protect the right of preference shareholders.
D. Non-Cumulative dividend preference shares: are preference shares with out the above
privilege.
E. Redemption /Maturity: Preference shares are usually perpetual or irredeemable, have no
a maturity date.
F. Call feature: The call feature permits the company to buy back preference shares at a
stipulated buy-back or (call price)
G. Participation feature:
Preference shares may in some case have participation feature which entitles preference
shareholders to participate in extraordinary profits earned by the company. This means that a
preference shareholder may get dividend amount in excess of the fixed dividend. Preference
shareholders may also be entitled to participate in the residual assets in the event of liquidation.
H. Voting Rights: Preference share ordinary do not have any voting right.
I. Convertibility:
Preference shares may be convertible or non-convertible. A convertible reference shares
allows preference shareholders to convert their preference shares, fully or partly, into ordinary
share at a stipulated price during a given period of time.
Pros and Cons of Preference Shares
Preference shares have a number of advantages to a company, which ultimately occur to ordinary
shareholders.
A. Riskless Leverage Advantage: Preference share provides financial leverage advantage
since preference dividend is fixed obligation. This advantage occurs with out a serious
risk of default. The non-payment of preference dividend does not force the company into
insolvency.
B. Dividend Postponabilitv: Preference share provides some financial flexibility to the
company since it can postpone payment of dividend.

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C. Fixed dividend: The preference dividend payments are restricted to the stated amount.
Thus, preference shareholders do not participate in excess profit as do the ordinary
shareholders.
D. Limited Voting Right: Preference shareholders do not have voting right except in case
dividend in arrears exists. Thus, control of ordinary shareholders is preserved.
The following are the limitations of preference shares:
A. Non-deductibility of dividends: The primary disadvantage of preference shares is that
preference dividend is not tax deductible. Thus, it is costlier than bonds.
B. Commitment to pay dividend: Although preference dividend can be omitted, they may
have to be paid because of their cumulative nature. Non-payment of dividends can
adversely affect the image of a company, since equity holders cannot be paid any
dividends unless preference shareholders are paid dividends.
Preference share provide more flexibility and less burden to a company. The dividend rate is less
than on equity and it is fixed. Also, the company can redeem it when it does not require the
capital. In practice, when a company recognizes its capital, it may convert preference capital into
equity.
3. Bonds
A bond is a long-term promissory note for raising loan capital. Interest and principle: The firm
promise to pay
Features of Bond Capital
A. Interest rate
The interest rate on a bonds is fixed and known. It is called the contractual rate of
interest. It indicates the percentage of par value of the debenture that will be paid out annually
(or semi-annually) in the form of interest, regardless of the market value.
B. Maturity
Debentures are issued for a specific period of time. The maturity of bonds indicates the
length of time until the company redeems (returns) the part value to debenture holders and
terminates the debentures.
C. Redemption
Bonds are mostly redeemable; they are redeemed on maturity. Redemption of debentures
can be accomplished either through a sinking fund or buy back (call) provision.

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I. Sinking fund: A sinking fund is cash set aside periodically for retiring debenture.
II. Buy-back (call) provision: buy back provisions enables the company to redeem
debentures at a specified price before the maturity date. The buy-back (call) price
may be more than the par value of the debentures. This difference is called call or
buy-back premium.
D. Indentures:
An indenture or debenture trust deed is a legal agreement between the company issuing
the debentures and the debenture trustee who represents the debenture holders.
E. Security:
Debentures are either secured or unsecured. A secured bond is secured by a lien on a
company's specific assets. When bonds are not protected by any security, they are known as
unsecured or naked debentures.
F. Prior Claim on assets and Income
Debenture (bond) holders have a claim on the company's earnings prior to that of
shareholders. Bond interest has to be paid before paying any dividend to preference and ordinary
shareholders. In liquidation, the bond holders have a claim on assets prior to that of shareholders.
However, secured debenture holders will have priority over the unsecured bond holders.
Pros and Ions of Bond capital
Bonds have a number of advantages as long-term source of finance.
A. Less Costly: It involves less cost to the firm than the equity financing because:
I. Inventors consider bonds as relatively less risky investment alternative and
therefore, require a lower rate and
II. Interest payments are tax deductible
B. No ownership dilution: Bond holders do not have voting right, therefore, bonds issue
does not cause dilution of ownership
C. Fixed Payments of Interest: Debenture holders do not participate in extra ordinary
earnings of the company. Thus the payments are limited to interest.
D. Reduced Real Obligation: During periods of high inflation, bond issue benefits the
company. Its obligation of paying interest and principal which are fixed decline in real
terms.
Debentures have some limitation also:

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A. Obligatory payments: debenture result in legal obligation of paying interest and

principle, which if not paid, can force the company into liquidation.
B. Financial Risk: It increase the firm’s financial leverage, which may be particularly
disadvantageous to those firms which have fluctuating sales and earnings
C. Cash Outflow: Debentures must be paid on maturity, and therefore, at some points, it
involves substantial cash outflow.
D. Restricted Covenant: Debenture indenture may contain restrictive covenant which may
limit the company’s operating flexibility in the futures.
Exercise
1. Selam Company expects to earn $ 16,000 next year before interest and taxes. sales will
be $ 130,000. The store is the only pizza parlor near to Mekelle University. The owner,
selam makes only one variety and size of pizza (the house special) and it sells for $ 10.
The variable cost per pizza is $ 6. Selam Company experiences a 48% tax rate.
Required:
A. What are the pizza parlor’s fixed costs expected to be next year?
B. Calculate the parlor’s break-even point in unit and dollars
2. You are supplied with the following analytical income statement for Omelets Shoppe. It
reflects last year’s operations.
Sales------------------------------------------------ $ 75,000
Variable costs------------------------------------- 37,000
Revenue before fixed cost----------------------- 38,000
Fixed costs----------------------------------------- 19,000
EBIT------------------------------------------------- 19,000
Interest expense------------------------------------ 7,000
Earnings before tax-------------------------------- 12,000
Taxes------------------------------------------------- 6,000
Net income------------------------------------------ 6,000
Required:
A. What is the degree of operation leverage at this level of output?
B. What is the degree of financial leverage?
C. What is the degree of combined leverage?

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D. If sales should increase by 30%, by what percent would earnings before interest
and taxes increase?
E. What is Omelets Shoppe break –even point in sales dollars?
3. The ESM Corporation projects that next year its fixed costs will total $ 120,000. Its only
product sells for $ 17 per unit, of which $ 9 is a variable cost. The management of ESM
is considering the purchase of a new machine that will lower the variable cost per unit to
$ 7. The new machine, however, will add to fixed costs through an increase in
depreciation expense.
Required: How large can the addition to fixed costs be in order to keep the firm’s break-
even point in units produced and sold unchanged?
4. The management of ESM Corporation decided not to purchase the new piece of
equipment. Using the existing cost structure, calculate the degree of operating leverage at
35,000 units of output.
5. Toys produce inflatable beach balls, selling 400,000 balls a year. Each ball produced has
a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs are $ 28,000.
The firm has annual interest charges of $6,000, preferred dividends of $ 2,000, and a 40%
tax rate.
Required: using the formula.
1. Calculated the operating breakeven point in units
2. calculate the Degree of operating leverage
3. Calculate the Degree of financial leverage
4. Calculate the Degree of Total Leverage. Compare this to the product of
Degree of operating and Financial leverage calculated in 2 and 3

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