CH.6 Financial Structure & The Uses of Leverage

FINANCIAL STRUCTURE
& FINANCIAL LEVERAGE

OBJECTIVES
 At the end of this chapter, you should be
able to:
Explain the effect of financing decisions of
capital structure & financial leverage
Identify the effect of change in sales & financing
decisions on the firm’s EPS
Determine the point of indifference and its
significance in financing decisions
INTRODUCTION
 What is leverage?
Leverage exists when a company has a debt
component in its capital structure
The more debt a company has the more is its
leverage
Leverage accelerates the profitability of a
company
Its enables a company to achieve greater rate
of profit as compared to one without leverage
FINANCIAL LEVERAGE
 Financial leverage concerns with the effects of financing decision on the
owners’ return, that is the relationship between a firm’s EBIT and EPS
Sales
Less: COGS
Gross profit Operating

leverage
Less: Operating expenses Combined
leverage
Operating profit
Less: Interest & taxes
Net profit Financial

leverage
Less: Preferred dividends
Earnings available to common

shareholders
CONT’D
 Financial leverage relates to the financing cost

of the firm (cost of debt or interest)
 Financial leverage has direct implications on risk
& return tradeoffs
The stockholder have less control of the firm
It represents higher risk to the creditors/lenders
 Our concern is the impact on EAT, and thus
EPS if there is a change in EBIT due to change
in sales level
 The degree of financial leverage (DFL) is
defined as the % change in EPS due to the
given % change in EBIT.
CONT”D
E.g RM 200,000 is needed to purchase the necessary
assets to run the business with common stock
issued at RM100 par value
Plan A:0% debt
Total debt 0
Common equity 200,000
Total assets RM200,000 Total liabilities & equity RM200,000
Plan B: 25% debt at 8% interest rate
Total debt 50,000
Plan B: 40% debt at 8% interest rate
Total debt 80,000
Cont’d
 Plan A (2,000 common shares outstanding)

No financial risk is assumed
 Plan B (1,500 common shares outstanding)

Moderate financial risk is assumed
 Plan C (1,200 common shares outstanding)

The most financial leverage is assumed
Cont’d : Analysis Of Financial Leverage At Different Ebit Levels
EBIT INTEREST EBT TAXES(50%) Net Inc. To EPS
Common
Plan A: 0% debt, RM 200,000 common equity; 2000 shares
0 0 0 0 0 0
20,000 0 20,000 10,000 10,000 5.00
40,000 0 40,000 20,000 20,000 10.00 100%
60,000 0 60,000 30,000 30,000 15.00
80,000 0 80,000 40,000 40,000 20.00
Plan B: 25% debt, 8% interest rate, RM 150,000 common equity; 1500 shares
0 4,000 (4,000) (2,000) (2,000) (1.33)
20,000 4,000 16,000 8,000 8,000 5.33
40,000 4,000 36,000 18,000 18,000 12.00 125%
60,000 4,000 56,000 28,000 28,000 18.67
80,000 4,000 76,000 38,000 38,000 25.33
Plan C: 40% debt, 8% interest rate, RM 120,000 common equity; 1200 shares
0 6,400 (6,400) (3,200) (3,200) 2.67
20,000 6,400 13,600 6,800 6,800 5.67
40,000 6,400 33,600 16,800 16,800 14.00 147%
60,000 6,400 53,600 26,800 26,800 22.33
80,000 6,400 73,600 36,800 36,800 30.67
Cont’d
Degree of financial leverage from base EBIT level
DFLEBIT = % change in EPS
% change in EBIT
Plan A : DFL20,000 = 100% =1.00 time
100%
Plan B : DFL20,000 = 125% =1.25 times
100%
Plan C : DFL20,000 = 147% =1.47 times
100%
When EBIT increase or decrease by certain percentage it will
cause the EPS to increase or decrease by 1x (Plan A),
1.25 X (Plan B) & 1.47 X (Plan C) greater than EBIT.
Cont’d
 DFLEBIT = Q(P-V)-F
Q(P-V)-F-I- (Ps div. X 1/(1-tax))
 DFLEBIT = EBIT
EBIT – I – (Ps div. X 1/(1-tax))
Plan A : DFL20,000 = 20,000 =1.00 time
20,000-0
Plan B : DFL20,000 = 20,000 =1.25 times
20,000-4,000
Plan C : DFL20,000 = 20,000 =1.47 times
20,000-6,400
Combining Operating & Financial Leverage
 Changes in sales cause changes in EBIT
 Changes in EBIT will cause changes in EPS &

earnings available to c/stockholders if the firm
chooses to use financial leverage
 Combining operating & financial leverage causes

rather large variations in EPS
 Refer to example in operating leverage & assume

that plan B, which carried a 25% debt ratio was
chosen to finance the company’s assets
Combined Leverage Analysis
Base Sales level Forecast sales level

Sales 300,000 360,000
Less: Total variable costs 180,000 216,000
Revenue before fixed costs 120,000 144,000
Less: Total fixed costs 100,000 100,000
EBIT 20,000 44,000
Less: Interest expense 4,000 4,000
EBT 16,000 40,000
Less: Taxes at 50% 8,000 20,000
Net Income 8,000 20,000
Less: Preferred dividends 0 0
Earnings available to common 8,000 20,000
Number of common shares 1,500 1,500
EPS 5.33 13.33
DOL300,000 = 120% = 6 times
20%
DFL300,000 = 150% = 1.25 times
120%
Cont’d
 DCLs = % change EPS or

% change in sales
 DCLs = DOLs X DFLs
= 6 X 1.25 = 7.5 times
 DCLs = Q (P – V)
Q (P – V)-F-I - (Ps div. X 1/(1-tax))
= 30,000(10-6)
30,000(10-6)-100,000-4,000
= 7.5 times
Summary of Leverage Concepts
 Breakeven Analysis
 Qb = F
P–V
S = F
1- VC
S
 Operating Leverage
DOLs = Q ( P – V )
Q (P - V) – F
 Financial leverage
DFL Ebit = EBIT
EBIT – I - (Ps div. X 1/(1-tax))
 Combined leverage
DCLs = Q (P – V)
Q (P – V)-F-I -(Ps div. X 1/(1-tax))
Exercise
 You have developed the following income statement for
your company. It represents the most recent year’s
operations, which ended yesterday
Sales 20,000,000
Variable Costs 12,000,000
Revenue before fixed costs 8,000,000
Fixed costs 5,000,000
EBIT 3,000,000
Interest expense 1,000,000
Earnings before taxes 2,000,000
Taxes (50%) 1,000,000
Net income 1,000,000
Cont’d
 At this level of output, what is the DOL?
 What is the DFL?
 What is the DCL
 If sales should increase by 30%, by what percent
would earnings before taxes increase?

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FINANCIAL STRUCTURE

& FINANCIAL LEVERAGE

Gross profit Operating

Less: Interest & taxes

Net profit Financial

Earnings available to common

 Financial leverage relates to the financing cost

 Plan A (2,000 common shares outstanding)

 Plan B (1,500 common shares outstanding)

 Plan C (1,200 common shares outstanding)

 Changes in sales cause changes in EBIT

 Changes in EBIT will cause changes in EPS &

 Combining operating & financial leverage causes

 Refer to example in operating leverage & assume

Base Sales level Forecast sales level

 DCLs = % change EPS or

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