LG 2 13.1 Leverage

LG 1 LG 2 13.1 Leverage

leverage Leverage refers to the effects that fixed costs have on the returns that shareholders

Refers to the effects that fixed

earn. By “fixed costs” we mean costs that do not rise and fall with changes in a

costs have on the returns that

firm’s sales. Firms have to pay these fixed costs whether business conditions are

shareholders earn; higher

good or bad. These fixed costs may be operating costs, such as the costs incurred

leverage generally results in higher but more volatile

by purchasing and operating plant and equipment, or they may be financial costs,

returns.

such as the fixed costs of making debt payments. Generally, leverage magnifies both returns and risks. A firm with more leverage may earn higher returns on average than a firm with less leverage, but the returns on the more leveraged firm will also be more volatile.

Many business risks are out of the control of managers, but not the risks associated with leverage. Managers can limit the impact of leverage by adopting strategies that rely more heavily on variable costs than on fixed costs. For example, a basic choice that many firms confront is whether to make their own products or to outsource manufacturing to another firm. A company that does its own manufacturing may invest billions in factories around the world. These fac- tories generate costs whether they are running or not. In contrast, a company that outsources production can completely eliminate its manufacturing costs simply by not placing orders. Costs for a firm like this are more variable and will gener- ally rise and fall as demand warrants.

In the same way, managers can influence leverage in their decisions about how the company raises money to operate. The amount of leverage in the firm’s capital structure

capital structure—the mix of long-term debt and equity maintained by the firm—

The mix of long-term debt and

can significantly affect its value by affecting return and risk. The more debt a firm

equity maintained by the firm.

issues, the higher are its debt repayment costs, and those costs must be paid regardless of how the firm’s products are selling. Because leverage can have such

a large impact on a firm, the financial manager must understand how to measure and evaluate leverage, particularly when making capital structure decisions. Table 13.1 uses an income statement to highlight where different sources of leverage come from.

TA B L E 1 3 . 1

General Income Statement Format and Types of Leverage

Sales revenue Less: Cost of goods sold

Operating leverage

Gross profits Less: Operating expenses

Earnings before interest and taxes (EBIT) Less: Interest

Total leverage

Net profits before taxes Less: Taxes

Financial leverage

Net profits after taxes Less: Preferred stock dividends

Earnings available for common stockholders Earnings per share (EPS)

CHAPTER 13

Leverage and Capital Structure

• Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits. When costs of operations (such as cost of goods sold and operating expenses) are largely fixed, small changes in revenue will lead to much larger changes in EBIT.

• Financial leverage is concerned with the relationship between the firm’s EBIT and its common stock earnings per share (EPS). On the income statement, you can see that the deductions taken from EBIT to get to EPS include interest, taxes, and preferred dividends. Taxes are clearly variable, rising and falling with the firm’s profits, but interest expense and preferred dividends are usu- ally fixed. When these fixed items are large (that is, when the firm has a lot of financial leverage), small changes in EBIT produce larger changes in EPS.

• Total leverage is the combined effect of operating and financial leverage. It is concerned with the relationship between the firm’s sales revenue and EPS.

We will examine the three types of leverage concepts in detail. First, though, we will look at breakeven analysis, which lays the foundation for leverage con- cepts by demonstrating the effects of fixed costs on the firm’s operations.