Fin man 6 financial leverage
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The document discusses the topics of leverage, including operating leverage and financial leverage. It provides definitions and formulas for calculating degrees of operating leverage (DOL) and financial leverage (DFL). Operating leverage results from fixed costs and increases volatility of earnings. Financial leverage magnifies profits but also losses through the use of debt financing. Both types of leverage can increase risk but also increase potential returns through profit magnification.
Fin man 6 financial leverage
- 1. Financial Management Class #6 ………………………………………………………………… Jimmi Sinton Te a c h i n g S e r i e s
- 2. 6-14 Financial Leverage Topics LEVERAGE Materials KEUANGAN Covered ………… …… pengertian dan jenis leverage leverage operasi: pengertian, menentukan tingkat DOL, analisa BEP dalam mempelajari leverage operasi leverage keuangan Please read each material hubungan leverage keuangan dengan operasi before class menentukan tingkat leverage keuangan (DFL) and rehearse it menentukan tingkat leverage kombinasi (DCL) after class indifference point antara hutang dan saham biasa J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 3. 6-14 Financial Leverage Leverage Analysis Leverage Analysis In physics, leverage refers to a multiplcation of a force into even larger forces In finance, it is similar, but we are refering to a multiplication of % changes in sales into even larger changes in profitability measures % ∆ Sales % ∆ Sales Financial % ∆ Sales Leverage % ∆ Profits FULCRUM J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 4. 6-14 Financial Leverage Leverage Analysis Types of Risk There are two main types of risk that a company faces: Business risk - the variability in a firm’s EBIT. This type of risk is a function of the firm’s regulatory environment, labor relations, competitive position, etc. Note that business risk is, to a large degree, outside of the control of managers. Financial risk - the variability in the firm’s EBT. This type of risk is a direct result of management decisions regarding the relative amounts of debt and equity in the capital structure J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 5. 6-14 Financial Leverage Operating Leverage J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 6. 6-14 Financial Leverage Leverage Analysis - Operating Leverage The Degree of Operating Leverage - DOL The degree of operating leverage is directly proportional to a firm’s level of business risk, and therefore it serves as a proxy for business risk Refers to a multiplication of changes in sales into even larger changes in EBIT Note that operating leverage results from the presence of fixed costs in the firm’s cost structure J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 7. 6-14 Financial Leverage Leverage Analysis - Operating Leverage OPERATING LEVERAGE What is it? How is it Increased? Operating leverage is: The increased volatility in operating income caused by fixed operating costs. Managers do make decisions affecting the cost structure of the firm. Managers can decide to invest in assets that give rise to additional fixed costs in intention to reduce variable costs. Commonly accomplished by a firm choosing to become more capital intensive and less labour intensive, thereby increasing operating leverage. J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 8. 6-14 Financial Leverage Leverage Analysis - Operating Leverage Operating Leverage Advantages and Disadvantages Advantages: Magnification of profits to the shareholders if the firm is profitable. Operating efficiencies (faster production, fewer errors, higher quality) usually result increasing productivity, reducing ‘downtime’ etc. Disadvantages: Magnification of losses to the shareholders if the firm is not profitable. Higher break even point High capital cost of equipment and the illiquidity of such an investment make it: Expensive (more difficult to finance) Potentially exposed to technological obsolescence, etc. J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 9. 6-14 Financial Leverage Leverage Analysis - Operating Leverage Calculating the DOL The degree of operating leverage can be calculated as: DOL with Two % E B IT income statement: DOL % S ales DOL with One Q p v S ales VC income statement: DOL Q p v FC E B IT J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 10. 6-14 Financial Leverage Financial Leverage J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 11. 6-14 Financial Leverage Capital Structure The mix of debt, preferred stock, and common stock the firm plans to use over the long-run to finance its operations The proportions should be set in such a way as to balance risk/return and thereby maximize the price of the stock J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 12. 6-14 Financial Leverage Leverage Analysis FINANCIAL LEVERAGE What is it? How is it Increased? Your textbook defines financial leverage as: The increased volatility in operating income caused by the corporate use of sources of capital that carry fixed financial costs. Financial leverage can be increased in the firm by: Selling bonds or preferred stock (taking on financial obligations with fixed annual claims on cash flow) Using the the debt to retire equity J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 13. 6-14 Financial Leverage Leverage Analysis – Financial Leverage Financial Leverage Advantages and Disadvantages Advantages: Magnification of profits to the shareholders if the firm is profitable. Lowering cost of capital to moderate levels of financial leverage, because interest expense is tax-deductible. Disadvantages: Magnification of losses to the shareholders if the firm is not profitable. Higher break even point. At higher levels of financial leverage, the low after-tax cost of debt is offset by other effects such as: Present value of the rising probability of bankruptcy costs Agency costs Lower operating income (EBIT), etc. J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 14. 6-14 Financial Leverage Leverage Analysis – Financial Leverage Leverage Analysis GOOD SIDE of Wolverine Corporation ($000) debt Leverage Scenarios The Degree of 1 2 3 Financial Leverage 0% Debt 50% Debt 80% Debt (DFL) Capital Debt $ - $ 500 $ 800 As the firm’s debt Equity 1,000 500 200 ratio rises, both EPS Total $ 1,000 $ 1,000 $ 1,000 Shares @ $10 100,000 50,000 20,000 and ROE rise Revenue $ 1,000 $ 1,000 $ 1,000 dramatically. While Cost/expense 800 800 800 EAT falls, the EBIT $ 200 $ 200 $ 200 number of shares Interest (10%) 0 50 80 EBT $ 200 $ 150 $ 120 outstanding falls at a Tax (40%) 80 60 48 faster rate as debt EAT $ 120 $ 90 $ 72 replaces equity. ROE 12% 18% 36% EPS $ 1.20 $ 1.80 $ 3.60 J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 15. 6-14 Financial Leverage Leverage Analysis – Financial Leverage Leverage Analysis BAD SIDE of Wolverine Corporation ($000) debt Leverage Scenarios The Degree of 1 2 3 Financial Leverage (DFL) 0% Debt 50% Debt 80% Debt Capital Debt $ - $ 500 $ 800 Wolfie is now Equity 1,000 500 200 Total $ 1,000 $ 1,000 $ 1,000 doing rather Shares @ $10 100,000 50,000 20,000 poorly—ROE are Revenue $ 800 $ 800 $ 800 quite low. As the Cost/expense 720 720 720 EBIT $ 80 $ 80 $ 80 firm adds leverage, Interest (10%) 0 50 80 EPS and ROE EBT $ 80 $ 30 $ - decrease. Tax (40%) 32 12 0 EAT $ 48 $ 18 $ - ROE 4.8% 3.6% 0% EPS $ 0.48 $ 0.36 $ - J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 16. 6-14 Financial Leverage Leverage Analysis – Financial Leverage The Degree of Financial Leverage (DFL) The DFL is a measure of the % changes in EBT that result from changes in EBIT, it is calculated as: DFL with Two % EBT income statement: D FL % E B IT DFL with One E B IT income statement: D FL EBT J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 17. 6-14 Financial Leverage Leverage Analysis – Financial Leverage The Degree of Combined Leverage (DCL) The degree of combined leverage is a measure of the total leverage (both operating and financial leverage) that a company is using: % EB T % EB IT % EB T DCL DOL D FL % Sales % Sales % EB IT It is important to note that DCL is the product (not the sum) of both DOL and DFL J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 18. 6-14 Financial Leverage Leverage Sa le s Bas e Cas e 1000 Sale s Down 10% Sale s up 10% 900 1100 Analysis – Va r ia b le Costs Fixe d Costs 450 300 405 300 495 300 Financial De p r e cia tion EBIT 100 150 100 95 100 205 Leverage Inte r e st Exp e nse 30 30 30 EBT 120 65 175 Pe rc e ntag e Chang e s Re lative to the Bas e Cas e Calculating Sa le s -10.000% 10.000% EBIT -36.667% 36.667% EBT -45.833% 45.833% Leverage Le ve rag e M e as ure s Measures Us ing a s ing le inc om e s tate m e nt: DOL 3.67 5.21 2.95 DFL 1.25 1.46 1.17 DCL 4.58 7.62 3.46 Us ing two inc om e s tate m e nts : DOL 3.67 DFL 1.25 DCL 4.58 J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 19. 6-14 Financial Leverage Leverage Analysis – Financial Leverage Comparing Operating and Financial Leverage FL and OL are similar in that both can enhance results while increasing variation FL involves substituting debt for equity in the firm’s capital structure OL involves substituting fixed costs for variable costs in the firm’s cost structure Both substituting fixed cash outflows for variable cash outflows Both kinds of leverage make their respective risks larger as the levels of leverage increase However, financial risk is non-existent if debt is not present, while business risk would still exist even if no operating leverage existed FL is more controllable than OL J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 20. 6-14 Financial Leverage Leverage Analysis – Financial Leverage Effects of Operating and Financial Leverage Summary Equity holders bear the added risks associated with the use of leverage. The higher the use of leverage (either operating or financial) the higher the risk to the shareholder. Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost of capital. HIGHER LEVERAGE = HIGHER COST OF CAPITAL J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 21. 6-14 Financial Leverage Indifference Point The level of sales at which EPS will be the same whether the firm uses debt or equity or prefered stock The indifference point between any two financing methods can be expressed mathematically: ( EBIT*- I1) (1-T) (EBIT*- I2) (1-T) = S1 S2 I1,I2= annual interest expenses or preferred dividends on a before tax basis S1,S2=number of common shares outstanding for methods 1 and 2. T= tax rate J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 22. 6-14 Financial Leverage Indifference Curve 6 Debt 5 Earnings per Share ($) Indifference point between debt and 4 common stock Common financing 3 2 1 0 0 100 200 300 400 500 600 700 EBIT ($ thousands) J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management
- 23. 6-14 Financial Leverage EXAMPLE 1: A company with long-term capitalization of $ 10 million consisting entirely of common stock wishes to raise another $5 million for expansion through one of the two possible financing plans.The company may finance with 1.All common stock 2.All debt at 9% EBIT is $ 1,400,000 and tax rate is 50%. 200,000 shares of stock are presently outstanding. Common stock can be sold at $ 50 per share.( 100,000 additional shares) In this example, the hypothetical level of EBIT is $ 2million. All Common All Debt EBIT 2,000,000 2,000,000 Interest 0 450,000 Earnings before taxes 2,000,000 1,550,000 Taxes 1,000,000 775,000 Net Income 1,000,000 775,000 Earnings available to Shareholders 1,000,000 775,000 Number of shares 300,000 200,000 J i m m i S ei ni t o n Earnings per share $3.33 $3.88 T e a c h i n g S r e s Financial Management
- 24. 6-14 Financial Leverage Indifference level of EBIT between debt and common stock financing: ( EBIT*- 0) (1-0.50)= (EBIT* –450,000) (1-0.50) 300,000 200,000 EBIT*(0.5) (200,000)= (EBIT (0.50)-450,000 (0.50)) 300,000 100,000EBIT*=135,000,000 EBIT*= $ 1,350,000 The indifference point between debt and common alternatives is at $ 1,350,000. If EBIT is below this amount, common stock financing will give higher EPS. If EBIT is above this amount debt financing will provide higher EPS. J i m m i S ei ni t o n T e a c h i n g S r e s Financial Management