Leverage

1
Leverage

• The use of fixed charge obligations with the goal
  of enhancing returns to the firm (while also
  exposing the firm to additional risks.)
• Two types of leverage
• Operating leverage (depends on use of fixed
  operating costsPlant Equipment, salaries,
  etc.)
• Financial leverage (depends on use of fixed
  financing costs--interest)

2
Operating Leverage (OL) and Financial Leverage
(FL) are Manifest in the Income statement as FC
and I
3
Why do we care about leverage?Consider a sole
proprietor making and selling baskets by the
road...
4
To calculate BEQ generally,

• We know that TCTR at BEQ.
• Therefore,
• (VC X BEQ) FC P X BEQ
• Solving for BEQ, we get
• BEQ FC/(P-VC)
• In our case, that means
• BEQ100/(5-1)25

5
Quantifying Operating Leverage and Financial
Leverage

• The Degree of Operating Leverage (DOL) is
  calculated as DOL(Sales-VC)/EBIT
• What does a higher DOL indicate? (consider the
  next slide)
• What is the lowest we would expect DOL to be and
  when would we see that?
• DOL can be used to forecast EBIT as follows
• (change in EBIT)DOL X ( change in Sales)
• The Degree of Financial Leverage (DFL) is
  calculated as DFLEBIT/(EBIT-I)
• What does a higher DFL indicate? (consider the
  slide after next)
• What is the lowest we would expect DFL to be and
  when would we see that?
• DFL can be used to forecast NI as follows
  
• ( change in NI)DFL X ( change in EBIT)

6
Consider two firms LOL and HOLCalculate and
compare the relative levels of DOL and the impact
of operating leverage on EBIT (double click on
spreadsheet)
7
Consider two more firms LFL and HFLCalculate
and compare the relative levels of DFL and the
impact of financial leverage on NI
8
Your Assignment

• For your firm
• Calculate your DOL, DFL, and debt ratio
• Compare them to industry norms (your teammates)
• Choose a new debt ratio you could move to
• Indicate specific steps you would take to get to
  new ratio, and
• Indicate the impact this change would have on the
  risk/return profile of the firm