Provide conceptual understanding of financial leverage and operating leverage. Assess the impact of financial leverage on the firm.
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1 Learning Objectives FINANCIAL LEVERAGE Provide conceptual understanding of financial leverage and operating leverage. Assess the impact of financial leverage on the firm.
2 A. Concept of Financial Leverage When the management decides to finance increments of assets with debt involving fixed cost, it is said to have introduced financial leverage. Financial leverage is thus a mixture of equity and debt. The leverage is expressed in the ratio of debt to equity.
3 A. Concept of Financial Leverage The object in introducing financial leverage is to earn more than the cost of debt from employment of assets in business, and thus increase earnings per share. When such earnings exceed the cost of debt leverage is said to be positive. But if incremental debt cost is not off set by additional earnings, leverage is negative.
4 B. Financial Leverage versus Operating Leverage Company has certain fixed costs due to employment of assets in business. If change in profits accompanying a change in value is greater than the percentage change in volume of operation, the situation is called operating leverage. This leverage directly varies with the ratio of fixed costs to total operating costs.
5 B. Financial Leverage versus Operating Leverage In contrast to operating leverage financial leverage is a mix of equity and debt. Financial leverage concerns with debt and equity on liabilities side of the balance sheet, while operating leverage affects its asset side. Operating leverage influences mix of plant and equipment, financial leverage determines how they are financed.
6 C. Impact of Financial Leverage. Earnings remaining the same, higher financial leverage increases earnings per share as they are distributed on smaller equity.
7 D. Degree of Financial Leverage. Degree of financial leverage measures the effect of a change in one variable on another. Degree of financial leverage (DFL) is defined as the percentage change in earnings per share (EPS) taking place as a result of a percentage change in earnings before interest & taxes (EBIT).
8 D. Degree of Financial Leverage. Percentage change in (EPS) (DFL) = Percentage change in (EBIT). For purposes of computation the formula for DFL can be conveniently restated as (EBIT). (DFL) = (EBIT)- C Where C is the annual interest expense or preferred stock dividend on a before tax basis.
9 D. Degree of Financial Leverage. With DFL finance manager can evaluate various financing plans and reach products financing and investment decisions. It also sets limit up to which management can expand business beyond which leverage is negative.
10 D. Degree of Financial Leverage. Financial leverage technique fails to recognize implicit cost of debt. When debt equity ratio rises, market price of share can fall as greater reliance on debt is perceived as financial risk. Further, it assumes that more and more doses of debt can be had at the same cost of debt. In reality more and more debt can be obtained only by increasing interest rates.
11 E. Combining Operating and Financial Leverage. When operating and financial leverages are combined a change in sales revenue causes magnified effect on the EPS. The degree of operating and financial leverage is combined in the following manner. Degree of operating leverage at X units = X(P-V) % Change in EBIT = (P-V) F % Change in Sales Where X Units sold; P Selling Price; V Variable cost per unit & F Total fixed cost.
12 E. Combining Operating and Financial Leverage. Degree of Financial leverage (DFL) = EBIT EBIT C Since EBIT is simply X(P-V) F ; above equation can be expressed as X(P-V) F X(P-V) F C Where C is annual interest cost or preferred stock dividends on a before tax basis.
13 E. Combining Operating and Financial Leverage. Combining equations of operating leverage and financial leverage we get degree of operating and financial leverage at X as under X(P-V) X(P-V) F -C We see that fixed financial cost C increases the degree of combined operating and financial leverage.
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