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Capital Structure > Thinking About Financial Leverage
Thinking About Financial Leverage
• Defining Financial Leverage
• Impacts of Financial Leverage
• Leverage Models
• Combining Operating Leverage and Financial Leverage
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Capital Structure > Thinking About Financial Leverage
Defining Financial Leverage
• Common ways to attain leverage include borrowing money, buying fixed assets
and using derivatives.
• Fixed obligations create leverage because they allow a company to finance
operations using more capital than the company independently possesses.
• Leverage is often expressed as a ratio and is specifically defined by the amount of
debt that a company uses relative to the company's assets.
• Proper use of financial leverage can result in increased return on equity up to a
certain level of operating income. but it also exposes shareholders to higher risk.
Sample Leverage Ratios
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Capital Structure > Thinking About Financial Leverage
Impacts of Financial Leverage
• If value is added from financial leveraging than the associated risk will not have a
negative effect.
• At an ideal level of financial leverage, a company's return on equity increases
because the use of leverage increases stock volatility, increasing its level of risk
which in turn increases returns.
• If earnings before interest and taxes are greater than the cost of financial leverage
than the increased risk of leverage will be worthwhile.
Return On Equity
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Capital Structure > Thinking About Financial Leverage
Leverage Models
• The Modigliani-Miller theorem states that in the absence of taxes, bankruptcy
costs, agency costs, and asymmetric information - and in an efficient market - the
value of a firm is unaffected by how that firm is financed.
• The theorem tells us that capital structure matters precisely because one or more
of these assumptions is violated. It also tells us which factors to look at to
determine optimal capital structure.
• The Degree of Financial Leverage (DFL) gives us the percentage change in
earnings given a change in operating income.
• The higher the DFL, the riskier the business.
Modigliani-Miller including Taxes
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Capital Structure > Thinking About Financial Leverage
Combining Operating Leverage and Financial Leverage
• Total leverage measures the sensitivity of earnings to changes in the level of a
company's sales.
• If the percentage change in earnings and the percentage change in sales are both
known, a company can simply divide the percentage change in earnings by the
percentage change in sales to determine total leverage.
• Companies usually choose one form of leverage over the other when analyzing
potential investments. A company utilizing both forms of leverage undertakes a
very high level of risk.
Total Leverage Equation 1
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Appendix
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Capital Structure
Key terms
• asymmetric information State of being regarding decisions on transactions where one party has more or better information than
the other.
• derivative A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant, an option,
etc.
• Earnings Per Share The amount of earnings per each outstanding share of a company's stock.
• financial leverage any technique to multiply gains and losses, such as by borrowing
• liquidity Availability of cash over short term: ability to service short-term debt.
• solvency The state of having enough funds or liquid assets to pay all of one's debts; the state of being solvent.
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Capital Structure
Modigliani-Miller including Taxes
The value of a levered firm equals the value of an unlevered firm plus the tax rate times the value of debt.
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Wikipedia. "Modigliani–Miller theorem." GNU FDL http://en.wikipedia.org/wiki/Modigliani%25E2%2580%2593Miller_theorem View on Boundless.com
Capital Structure
Total Leverage Equation 3
TL = Total Leverage. P = Unit Revenue. V = Unit Variable Cost. X = Units Sold. FC = Fixed Costs. I = Interest Expense.
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Wikipedia. "Financial leverage." GNU FDL http://en.wikipedia.org/wiki/Financial_leverage#cite_note-13 View on Boundless.com
Capital Structure
Financial Leverage
Financial leverage is defined as the ratio of operating income to net income.
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Wikipedia. "Financial leverage." GNU FDL http://en.wikipedia.org/wiki/Financial_leverage View on Boundless.com
Capital Structure
Total Leverage Equation 1
Total leverage = DOL x DOF
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Wikipedia. "Financial leverage." GNU FDL http://en.wikipedia.org/wiki/Financial_leverage#cite_note-13 View on Boundless.com
Capital Structure
Sample Leverage Ratios
This graph shows leverage ratios for major investment banks.
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Wikimedia. "Leverage Ratios." CC BY-SA http://commons.wikimedia.org/wiki/File%253ALeverage_Ratios.png View on Boundless.com
Capital Structure
Return On Equity
The equation used to calculate return on equity.
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Wikipedia. "Return on Equity." GNU FDL http://en.wikipedia.org/wiki/Return_on_Equity View on Boundless.com
Capital Structure
Degree of Financial Leverage
DFL is equal to EBIT divided by EBIT minus interest expense (I), minus preferred dividends (P) divided by 1 minus the tax rate (T).
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OER Commons. "n/a." CC BY http://www.oercommons.org/courses/management-of-capital/view View on Boundless.com
Capital Structure
Total Leverage Equation 2
Total leverage = DOL x DOF
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Wikipedia. "Financial leverage." GNU FDL http://en.wikipedia.org/wiki/Financial_leverage#cite_note-13 View on Boundless.com
Capital Structure
Which of the following is a common way for a business to obtain
leverage?
A) Borrow money from a financial institution.
B) Purchase fixed assets, such as machinery or land.
C) Sell commercial paper that it issues on the open market.
D) All of these answers.
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Capital Structure
Which of the following is a common way for a business to obtain
leverage?
A) Borrow money from a financial institution.
B) Purchase fixed assets, such as machinery or land.
C) Sell commercial paper that it issues on the open market.
D) All of these answers.
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Capital Structure
Which of the following regarding the possible financial impacts of
leverage of a company is correct?
A) At an ideal level of financial leverage, a company's return on equity
decreases.
B) Leverage increases risk, which decreases a stock's value.
C) All of these answers.
D) Involuntary leverage is typically caused by eroding equity value, not
additional debt.
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Capital Structure
Which of the following regarding the possible financial impacts of
leverage of a company is correct?
A) At an ideal level of financial leverage, a company's return on equity
decreases.
B) Leverage increases risk, which decreases a stock's value.
C) All of these answers.
D) Involuntary leverage is typically caused by eroding equity value, not
additional debt.
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Capital Structure
A company has an EBIT of $2.5 million, with an interest expense
of $800,000 and preferred dividends of $700,000. Its tax rate is
35%. What is this company's degree of financial leverage?
A) 4.39
B) 1.47
C) 1.75
D) 4.01
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Capital Structure
A company has an EBIT of $2.5 million, with an interest expense
of $800,000 and preferred dividends of $700,000. Its tax rate is
35%. What is this company's degree of financial leverage?
A) 4.39
B) 1.47
C) 1.75
D) 4.01
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Capital Structure
A company sells 150,000 units at $60 a unit with a variable cost of
$30 a unit. It has $1 million in fixed costs and $600,000 in interest
costs. What is the company's total leverage?
A) 1.28
B) 1.21
C) 1.55
D) 1.15
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Capital Structure
A company sells 150,000 units at $60 a unit with a variable cost of
$30 a unit. It has $1 million in fixed costs and $600,000 in interest
costs. What is the company's total leverage?
A) 1.28
B) 1.21
C) 1.55
D) 1.15
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Capital Structure
Attribution
• Wikipedia. "Financial leverage." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_leverage
• Wikipedia. "Return on Equity." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Return_on_Equity
• Wiktionary. "liquidity." CC BY-SA 3.0 http://en.wiktionary.org/wiki/liquidity
• Wiktionary. "solvency." CC BY-SA 3.0 http://en.wiktionary.org/wiki/solvency
• Wikipedia. "asymmetric information." CC BY-SA 3.0 http://en.wikipedia.org/wiki/asymmetric%252520information
• Wikipedia. CC BY-SA 3.0
http://en.wikipedia.org/w/index.php?title=Modigliani%252525E2%25252580%25252593Miller_theorem&printable=yes
• Wikipedia. "Financial leverage." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_leverage
• OER Commons. CC BY-SA http://www.oercommons.org/courses/management-of-capital/view
• Wikipedia. "Financial leverage." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_leverage
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/earnings-per-share
• Wikipedia. "Financial leverage." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Financial_leverage
• Autoi. CC BY-SA http://www.autoi.org/24/t-605224.html
• Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//business/definition/financial-leverage
• Wikipedia. "derivative." CC BY-SA 3.0 http://en.wikipedia.org/wiki/derivative
• OER Commons. CC BY-SA http://www.oercommons.org/courses/management-of-capital/view
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