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Leverage
Financial management and control systems (Lecture 2)
Dr. Mahmoud Otaify
Assistant Professor of Finance
Leverage – Basic Concepts
What How Why
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Define
leverage
1
Differentiate
between
operating and
financial
leverage
2
Calculate
degree of
operating
leverage
3
Calculate
degree of
financial
leverage
4
Measure
Impact of
Financial
leverage
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What is Leverage?
Operating
Leverage
Sales Revenues
Less: Cost of Goods Sold (COGS)
Gross Profit
Less: Operating Exp.
Earnings Before Interest & Taxes (EBIT)
Financial
Leverage
EBIT
Less: interest
EBT
Less: taxes
Net income after tax
Less: Preferred Stock Dividends
Earnings Available for Common stocks (EACS)
Divide: Number of Shares
Earnings Per shares
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Total
Leverage
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What is Leverage?
Leverage
Depreciation, rents,
wages for salaried
employees
Operating Leverage
Interest on bank
loans/bonds, preferred
stock dividends
Financial Leverage
the use of fixed
costs in a
company’s cost
structure.
Regardless sales
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𝐷𝑂𝐿
=
%∆ in EBIT
% ∆ 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠
Sales Revenues
Less: Cost of Goods Sold (COGS)
Gross Profit
Less: Operating Exp.
Earnings Before Interest & Taxes (EBIT)
𝐷𝑭𝐿
=
%∆ in 𝐄𝐏𝐒
% ∆ 𝑖𝑛 𝑬𝑩𝑰𝑻
EBIT
Less: interest
EBT
Less: taxes
Net income after tax
Less: Preferred Stock Dividends
Earnings Available for Common stocks (EACS)
Divide: Number of Shares
Earnings Per shares
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𝐷𝑻𝐿
=
%∆ in 𝐄𝐏𝐒
% ∆ 𝑖𝑛 𝑺𝒂𝒍𝒆𝒔
How to Calculate Degree of Leverage?
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Example on Operating Leverage
Using the data for ALEX (sales, 1000 units, sale price, P
= $10 per unit; variable operating cost, VC = $5 per
unit; fixed operating cost, FC = $2,500).
Calculate the degree of operating leverage under the
following cases:
Case 1: an increase in the firm’s sales increase from
1,000 to 1,500 units
Case 2: a decrease in the firm's sales from 1,000 to 500
units
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Base Case Case 1 Case 2
Sales (in units) 1000 1,500 500
Sales revenue 1000*10=10,000 1,500*10=15000 500*10=5000
Less: Variable
operating costs
1000*5=5000 1500*5=7,500 500*5=2,500
Less: Fixed
operating costs
2,500 2,500 2,500
Earnings before
interest and
taxes (EBIT)
2,500 5,000 $0
% ∆ 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 1500-1000/1000 = 0.5 = 50% 500-1000/1000 = -0.5
=-50%
%∆ 𝐢𝐧 𝐄𝐁𝐈𝐓 5000-2,500/2,500 = 1 =100% 0 – 2,500/2500 = -1
= -100%
𝑫𝑶𝑳 =
%∆ 𝐢𝐧 𝐄𝐁𝐈𝐓
% ∆ 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔
𝐷𝑂𝐿 =
100
50
= 2 𝐷𝑂𝐿 =
−100
−50
= 2
comment A 50% increase in sales (from
1,000 to 1,500 units) results in a
100% increase in earnings before
interest and taxes (from $2,500
to $5,000).
A 50% decrease in sales (from 1,000 to
500 units) results in a 100% decrease
in earnings before interest and taxes
(from $2,500 to $0).
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Example on Financial Leverage
Borg Foods, a small food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with
a 10% (annual) coupon rate of interest and an issue of
600 shares of $4 (annual dividend per share) preferred
stock outstanding. It also has 1,000 shares of common
stock outstanding. Assume that the firm is in the 40%
tax bracket. Calculate the degree of financial leverage
under the following cases:
Case 1 An increase in EBIT to 14,000
Case 2 A decrease in EBIT to 6,000
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Base Case Case 1 Case 2
EBIT 10,000 14,000 6,000
Less Interest 0.1*20,000 =2000 2000 2000
EBT 8,000 12,000 4,000
Taxes (40%) 8000*0.4
=3,200
12,000*0.4 = 4,800 4000*0.4 = 1600
Net profit after taxes 4,800 7,200 2,400
Less preferred stock
dividends
4*600
=2,400
2,400 2,400
Earnings available for
common (EAC)
2,400 4,800 0
Earnings per share
(EPS)
2,400/1000
=2.4
4,800/1000 = 4.8 0/1000 = $0
% ∆ 𝒊𝒏 𝑬𝑩𝑰𝑻 14,000-10,000/10,000 = 40% 6000-10,000/10000 = -40%
%∆ 𝒊𝒏 𝑬𝑷𝑺 4.8-2.4/2.4 = 1 = 100% 0-2.4/2.4 = -1 = -100%
Comment A 40% increase in EBIT (from
$10,000 to $14,000) results in
a 100% increase in earnings
per share (from $2.40 to
$4.80).
A 40% decrease in EBIT (from $10,000 to
$6,000) results in a 100% decrease in
earnings per share (from $2.40 to $0).
𝑫𝑭𝑳 =
%∆ 𝒊𝒏 𝑬𝑷𝑺
% ∆ 𝒊𝒏 𝑬𝑩𝑰𝑻
𝑫𝑭𝑳 =
𝟏𝟎𝟎
𝟒𝟎
= 𝟐. 𝟓 𝑫𝑭𝑳 =
−𝟏𝟎𝟎
−𝟒𝟎
= 𝟐.𝟓
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What is risk of
Leverage?
Dr. Mahmoud Otaify - FMCS: Lec. 4 Leverage
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The greater the firm’s fixed
operating costs (operating
leverage)
The higher its business risk
The risk to the firm of being
unable to cover its operating
costs
The more fixed financing—debt
(including financial leases) and
preferred stock—a firm has in its
capital structure
the greater its financial risk
The risk to the firm of being
unable to cover its financing
costs
Greater probability of bankruptcy
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7. 10/13/2022
 https://www.youtube.com/watch?v=kadnjTgBmbA
 https://www.youtube.com/watch?v=Pz34ptgO5Bc
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