Impact and Analysis of Leverage

Impact and Analysis

  

Impact and Analysis

of Leverage of Leverage

  

Impact and Analysis

Impact and Analysis

  

of Leverage

of Leverage

  What is What is

  

Leverage?

Leverage?

  What is What is

  

Leverage?

Leverage?

  Two concepts that Two concepts that enhance our enhance our understanding of risk... understanding of risk...

  

1) Operating Leverage - affects

a firm’s business risk .

  2) Financial Leverage - affects a firm’s financial risk .

  Business Risk Business Risk

   The variability or uncertainty of a firm’s operating income (EBIT).

  

Analytical Income Statement

Analytical Income Statement

sales - variable costs - fixed costs operating income (EBIT) - interest EBT - taxes net income

  Business Risk Business Risk

  Affected by: 

  Sales volume variability 

  Competition 

  

Product diversification



  Operating leverage 

  Growth prospects 

  Size

  EBIT

  EBIT

Operating

Leverage

  Financial Risk Financial Risk

  

The variability or uncertainty of a

  

firm’s earnings per share (EPS)

and the increased probability of

insolvency that arises when a firm uses financial leverage .

  Financial Leverage Financial Leverage

   The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

  EPS

  EPS

Financial

Leverage

  Financial Leverage Financial Leverage

  Financial Leverage -- The use of Financial Leverage -- The use of

fixed financing costs by the firm.

fixed financing costs by the firm.

  

  Used as a means of increasing the return to common shareholders.

  Financial Leverage Financial Leverage

   Financial leverage : by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share.

  EBIT-EPS Break-Even, EBIT-EPS Break-Even, or Indifference Analysis or Indifference Analysis

  Calculate EPS EPS for a given level of EBIT

  EBIT at a

given financing structure.

  EBIT-EPS Break-Even Analysis EBIT-EPS Break-Even Analysis -- Analysis -- Analysis

of the effect of financing alternatives on

of the effect of financing alternatives on

earnings per share. The break-even point is

earnings per share. The break-even point is

the EBIT level where EPS is the same for

the EBIT level where EPS is the same for

two (or more) alternatives two (or more) alternatives . . (EBIT EBIT - I) (1 - t) - Pref. Div. # of Common Shares EPS EPS =

  EBIT-EPS Chart EBIT-EPS Chart

   Current common equity shares = 50,000 Current common equity shares = 50,000 _

  $1 million in new financing of either: $1 million in new financing of either: _ All C.S. sold at $20/share (50,000 shares) _ All debt with a coupon rate of 10% _ All P.S. with a dividend rate of 9% _ Expected EBIT = $500,000

  Expected EBIT = $500,000 _ Income tax rate is 30% Income tax rate is 30% Basket Wonders Basket Wonders has $2 million in LT financing has $2 million in LT financing

(100% common stock equity).

  

(100% common stock equity).

  EBIT-EPS Calculation with EBIT-EPS Calculation with

  

New Equity Financing

New Equity Financing

  Common Stock Equity Alternative Common Stock Equity Alternative * EBIT $500,000 $150,000 EBIT $500,000 $150,000 Interest 0 0 EBT $500,000 $150,000 Taxes (30% x EBT) 150,000 45,000 EAT $350,000 $105,000 Preferred Dividends 0 0 $350,000 $105,000 $350,000 $105,000 # of Shares 100,000 100,000 EPS $3.50 $1.05 EPS $3.50 $1.05

  EBIT-EPS Chart EBIT-EPS Chart

  0 100 200 300 400 500 600 700 ^{0 100 200 300 400 500 600 700} EBIT ($ thousands) EBIT ($ thousands) E ar n in g s p er S h ar e ($ ) E ar n in g s p er S h ar e ($ )

  1 ^{1 2 2 3 3 4 4 5 5 6 6} Common Common

  EBIT-EPS Calculation with EBIT-EPS Calculation with

  New Debt Financing New Debt Financing

  Long-term Debt Alternative Long-term Debt Alternative * EBIT $500,000 $150,000 EBIT $500,000 $150,000 Interest 100,000 100,000 EBT $400,000 $ 50,000 Taxes (30% x EBT) 120,000 15,000 EAT $280,000 $ 35,000 Preferred Dividends 0 0 $280,000 $ 35,000 $280,000 $ 35,000 # of Shares 50,000 50,000 EPS $5.60 $0.70 EPS $5.60 $0.70

  EBIT-EPS Chart EBIT-EPS Chart

  0 100 200 300 400 500 600 700 ^{0 100 200 300 400 500 600 700} EBIT ($ thousands) EBIT ($ thousands) E ar n in g s p er S h ar e ($ ) E ar n in g s p er S h ar e ($ )

  1 ^{1 2 2 3 3 4 4 5 5 6 6} Common Common Debt Debt Indifference point _{between debt debt and common stock common stock} financing

  EBIT-EPS Calculation with EBIT-EPS Calculation with

  New Preferred Financing New Preferred Financing

  Preferred Stock Alternative Preferred Stock Alternative * EBIT $500,000 $150,000 EBIT $500,000 $150,000 Interest 0 0 EBT $500,000 $150,000 Taxes (30% x EBT) 150,000 45,000 EAT $350,000 $105,000 Preferred Dividends 90,000 90,000 $260,000 $ 15,000 $260,000 $ 15,000 # of Shares 50,000 50,000 EPS $5.20 $0.30 EPS $5.20 $0.30

  0 100 200 300 400 500 600 700 ^{0 100 200 300 400 500 600 700} EBIT-EPS Chart

  EBIT-EPS Chart EBIT ($ thousands) EBIT ($ thousands) E ar n in g s p er S h ar e ($ ) E ar n in g s p er S h ar e ($ )

  1 ^{1 2 2 3 3 4 4 5 5 6 6} Common Common Debt Debt Indifference point _{between preferred preferred stock stock and common common} stock ^{stock financing}

  Preferred Preferred

  Degree of Financial Degree of Financial

  Leverage (DFL) Leverage (DFL)

  DFL

  DFL at

  EBIT of X dollars Degree of Financial Leverage

  Degree of Financial Leverage -- The

  percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit. = Percentage change in earnings per share (EPS) Percentage change in operating profit (EBIT)

  Computing the DFL Computing the DFL

  DFL

  DFL _{EBIT of $X}

  Calculating the DFL

  Calculating the DFL

  = EBIT

  EBIT

  EBIT

  EBIT

  I

  PD

• - I
• - [ PD

   / (1 - t

  t ) ] EBIT EBIT = Earnings before interest and taxes = Earnings before interest and taxes

  I I = Interest = Interest PD PD = Preferred dividends = Preferred dividends t t = Corporate tax rate = Corporate tax rate

  What is the DFL for Each What is the DFL for Each of the Financing Choices? of the Financing Choices?

  

Calculating the DFL for NEW equity alternative

Calculating the DFL for NEW equity * alternative $500,000

  $500,000

  DFL

  DFL $500,000 $500,000 =

  $500,000 )]

  $500,000 - 0 - [0 / (1 - 0 =

  

1.00

  1.00

  What is the DFL for Each What is the DFL for Each of the Financing Choices? of the Financing Choices?

  DFL

  DFL _{$500,000 $500,000} Calculating the DFL for Calculating the DFL for

  NEW NEW debt debt * alternative alternative

  = $500,000

  $500,000 { { $500,000 $500,000

  100,000

• - 100,000
• - [0 / (1 - 0 )] } =

  $500,000 $500,000 / $400,000

  

1.25

  

1.25

  =

  What is the DFL for Each What is the DFL for Each of the Financing Choices? of the Financing Choices?

  DFL

  DFL _{$500,000 $500,000} Calculating the DFL for Calculating the DFL for

  NEW NEW preferred preferred * alternative alternative

  = $500,000

  $500,000 { { $500,000 $500,000

• - 0 - [90,000

  90,000

   / (1 - .30

  .30 )] }

  =

  $500,000 $500,000 / $371,428

  1.35

  1.35

  =

  Variability of EPS Variability of EPS

  DFL = 1.00 Which financing

  DFL = 1.00 _{Equity Equity} method will have

  DFL = 1.25

  DFL = 1.25 _{Debt Debt}

  greatest relative

  the greatest relative

  variability in EPS?

  variability in EPS?

  DFL =

  1.35 DFL = _{Preferred Preferred}

  1.35 

  

Preferred stock financing will lead to

  Preferred stock the greatest variability in earnings per share based on the DFL.

  

  This is due to the tax deductibility of

  Total Firm Risk Total Firm Risk -- The variability in earnings per -- The variability in earnings per

share (EPS). It is the sum of business plus

share (EPS). It is the sum of business plus

financial risk.

financial risk.

  Total Firm Risk Total Firm Risk

• + financial risk financial risk

  Total firm risk Total firm risk = business risk

business risk

  Degree of Total Degree of Total

  Leverage (DTL) Leverage (DTL)

  DTL

  DTL at Q units

  (or S dollars) of output (or sales) Degree of Total Leverage

  

Degree of Total Leverage -- The

  percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in output (sales). = Percentage change in earnings per share (EPS) Percentage change in output (or sales)

• - I
• - [ PD

• - V
• - [ PD

  Q

  Q

   (P

  P -

  V )

  Q

  Q

   (P

  P - - V

  V

  ) - FC - I

  I

  PD

   / (1 - t

  t ) ]

  DTL _{Q units}

  DTL

  t ) ]

  ) x ( DFL

  Computing the DTL Computing the DTL

   _{S dollars of sales}

  DTL

  DTL _{Q units (or S dollars) Q units (or S dollars)}

  = ( DOL

  

DOL

_{Q units (or S dollars) Q units (or S dollars)}

  DFL _{EBIT of X dollars EBIT of X dollars}

   / (1 - t

  ) = EBIT

  EBIT + FC

  EBIT

  EBIT

  I

  PD

  =

  DTL Example DTL Example

  Lisa Miller wants to determine the Degree of Total Leverage

  

Degree of Total Leverage at

EBIT=$500,000.

  

EBIT=$500,000. As we did earlier, we

  will assume that:

   Fixed costs Fixed costs are $100,000 $100,000 _

  Baskets are sold for $43.75 $43.75 each each _ Variable costs are $18.75 per basket $18.75 per basket

  1.20 _{*Note: No financial leverage.}

  ) x (DFL

  1.20

  =

  1.20

  1.0

  ) x ( 1.0

  1.2

  = (1.2

  DTL _{S dollars S dollars}

  ) DTL

  DFL _{EBIT of $S EBIT of $S}

  DOL _{S dollars S dollars}

  = (DOL

  DTL _{S dollars S dollars}

  DTL

• * ) = 1.20

  .3 ) ]

  

$500,000

  $500,000

  $500,000 + $100,000

  = $500,000

  DTL _{S dollars of sales}

  DTL

  

Computing the DTL

Computing the DTL

for All-Equity Financing for All-Equity Financing

• - 0 - [ 0 / (1 - .3

  1.50 _{*Note: Calculated on Slide 16-27.}

  DOL _{S dollars S dollars}

  1.50

  =

  1.50

  1.25

  ) x ( 1.25

  1.2

  = (1.2

  DTL _{S dollars S dollars}

  ) DTL

  DFL _{EBIT of $S EBIT of $S}

  ) x (DFL

  = (DOL

  DTL _{S dollars S dollars}

  DTL

• * ) = 1.50

  .3 ) ] }

  $100,000

   $500,000

  { $500,000

  $500,000 + $100,000

  = $500,000

  DTL _{S dollars of sales}

  DTL

  Computing the DTL Computing the DTL for Debt Financing for Debt Financing

• - $100,000
• - [ 0 / (1 - .3

  Risk versus Return Risk versus Return

  Compare the expected EPS to the DTL for the common stock equity financing approach to the debt financing approach.

  Financing

  Financing

  E(EPS)

  DTL

  DTL Equity

  Equity

  $3.50

  $3.50

  1.20

  1.20 Debt Debt

  $5.60

  $5.60

  1.50

  1.50 Greater expected return (higher EPS) comes at

Greater expected return (higher EPS) comes at

the expense of greater potential risk (higher DTL)!

the expense of greater potential risk (higher DTL)!