Capital Structure &Leverage

Leverage results from the use of fixed-cost assets or funds to magnify returns to the
firm’s owners. Generally, increases in leverage result in increased return and risk,
whereas decreases in leverage result in decreased return and risk. The amount of
leverage in the firm’s capital structure – the mix of long-term debt and equity
maintained by the firm – can significantly affect its value by affecting return and risk.
Unlike some causes of risk, management has almost complete control over the risk
introduced through the use of leverage. Because of its effect on value, the financial
manager must understand how to measure and evaluate leverage, particularly when
making capital structure decisions.

The three basic types of leverage can best be defined with reference to the firm’s
income statement, as shown in the general income statement format in Table 1.

 Operating leverage is concerned with the relationship between the firm’s sales
revenue and its earnings before interest and taxes, or EBIT. (EBIT is a
descriptive label for operating profits.)

 Financial leverage is concerned with the relationship between the firm’s EBIT
and its common stock earnings per share (EPS).

 Total leverage is concerned with the relationship between the firm’s sales
revenue and EPS.

We will examine the three types of leverage concepts in detail.

TABLE 1
General Income Statement Format and Types of Leverage
Sales revenue
Operating leverage Less: Cost of goods sold
Gross profits
Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest
Net profits before taxes Total leverage
Financial leverage Less: Taxes
Net profits after taxes
Less: Preferred stock dividends
Earnings available for common stockholders

Earnings per share (EPS)

Operating Leverage
Operating leverage results from the existence of fixed operating costs in the firm’s
income stream. we can define operating leverage as the potential use of fixed
operating costs to magnify the effects of changes in sales on the firm’s earnings before
interest and taxes.
TABLE 2
The EBIT for Various Sales Levels
Case 2 Case 1

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 -50% +50%
Sales (in units) 500 1,000 1,500

Sales revenue a $5,000 $10,000 $15,000

Less: Variable operating costs b 2,500 5,000 7,500
Less: Fixed operating costs 2,500 2,500 2,500
Earnings before interest and taxes (EBIT) $ 0 $ 2,500 $ 5,000

-100% +100%
a Sales revenue = $10/unit X sales in units
b Variable operating costs = $5/unit X sales in units

Example
Using the data for Cheryl’s Posters (sale price, P = $10 per unit; variable operating
cost, VC = $5 per unit; fixed operating cost, FC = $2,500), The additional notations
indicate that as the firm’s sales increase from 1,000 to 1,500 units its EBIT increases
from $2,500 to $5,000. In other words, a 50% increase in sales (1,000 to 1,500 units)
results in a 100% increase in EBIT ($2,500 to $5,000). We can illustrate two cases
using the 1,000 unit sales level as a reference point.

Case 1 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).

Case 2 A 50% decrease in sales (from 1,000 to 1,500 units) results in a 100%
decrease in earnings before interest and taxes (from $2,500 to $0).

From the preceding example, we see that operating leverage works in both directions.
When a firm has fixed operating costs, operating leverage is present. An increase in
sales results in a more-than-proportional increase in EBIT; a decrease in sales results
in a more-than-proportional decrease in EBIT.

Measuring the Degree of Operating Leverage (DOL)

The degree of operating leverage (DOL) is the numerical measure of the firm’s
operating leverage. It can be derived using the following equation:

DOL = Percentage change in EBIT (1)

Percentage change in sales

Whenever the percentage change in EBIT resulting from a given percentage change in
sales is greater than the percentage change in sales, operating leverage exists. This
means that as long as DOL is greater than 1, there is operating leverage.

Example
Applying Equation 1 to cases 1 and 2 in Table 2 yields the following results:

Case 1: +100% = 2.0

+50%

2
Case 2: -100% = 2.0
-50%

Because the result is greater than 1, operating leverage exists. For a given base level
of sales, the higher the value resulting from applying Equation 1, the greater the
degree of operating leverage.

A more direct formula for calculating the degree of operating leverage at a base sales
level, Q, is shown in Equation 2.

DOL at base sales level Q = ___Q X (P – VC)__ (2)

Q x (P – VC) – FC

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into Equation 2 yields the
following result:

DOL at 1,000 units = ___1,000 X ($10 - $5) ____ = $5,000 = 2.0

1,000 X ($10 - $5) - $2,500 $2,500

The use of the formula results in the same value for DOL (2.0) as that found by using
Table 2 and Equation 1.

Fixed Costs and Operating Leverage

Changes in fixed operating costs affect operating leverage significantly. Firms
sometimes can incur fixed operating costs rather than variable operating costs and at
other times may be able to substitute one type of cost for the other. For example, a
firm could make fixed-dollar lease payments rather than payments equal to a specified
percentage of sales. Or it could compensate sales representatives with a fixed salary
and bonus rather than on a percent-of-sales commission basis. The effects of changes
in fixed operating costs on operating leverage can best be illustrated by continuing our
example.

Example
Assume that Cheryl’s Posters exchange a portion of its variable operating costs for
fixed operating costs by eliminating sales commissions and increasing sales salaries.
This exchange results in a reduction in the variable operating cost per unit from $5 to
$4.50 and an increase in the fixed operating costs from $2,500 to $3,000. Table 3
presents an analysis like that in Table 2, but using the new costs. Although the EBIT of
$2,500 at the 1,000 unit sales level is the same as before the shift in operating cost
structure, Table 3 shows that the firm has increased its operating leverage by shifting
to greater fixed operating costs.

With the substitution of the appropriate values into Equation 2, the degree of operating
leverage at the 1,000 unit base level of sales becomes

DOL at 1,000 units = ___1,000 X ($10 - $4.50)____ = $5,500 = 2.2

1,000 X ($10 - $4.50) - $3,000 $2,500

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 TABLE 3
Operating Leverage and Increased Fixed Costs
Case 2 Case 1

-50% +50%
Sales (in units) 500 1,000 1,500

Sales revenue a $5,000 $10,000 $15,000

Less: Variable operating costs b 2,250 4,500 6,750
Less: Fixed operating costs 3,000 3,000 3,000
Earnings before interest and taxes (EBIT) $ 250 $ 2,500 $ 5,250

-110% +110%
a Sales revenue was calculated as indicated in Table 2.
b Variable operating costs = $4.50/unit X sales in units.

Comparing this value to the DOL of 2.0 before the shift to more fixed costs makes it is
clear that the higher the firm’s fixed operating costs relative to variable operating costs,
the greater the degree of operating leverage.

Financial Leverage
Financial leverage results from the presence of fixed financial costs in the firm’s
income stream. Using the framework in Table 1, we can define financial leverage as
the potential use of fixed financial costs to magnify the effects of changes in earnings
before interest and taxes on the firm’s earnings per share. The two fixed financial costs
that may be found on the firm’s income statement are (1) interest on debt and (2)
preferred stock dividends. These charges must be paid regardless of the amount of
EBIT available to pay them.

Example
Chen Foods, a small Oriental 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. The annual interest on the bond
issue is $2,000 (0.10 X $20,000). The annual dividends on the preferred stock are
$2,400 ($4.00/share X 600 shares). Table 4 presents the EPS corresponding to levels
to EBIT of $6,000, $10,000, and $14,000, assuming that the firm is in the 40% tax
bracket. Two situations are shown:

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 TABLE 4
The EPS for Various EBIT Levels a

Case 2 Case 1

-40% +40%
EBIT $6,000 $10,000 $14,000
Less: Interest (I) 2,000 2,000 2,000
Net profits before taxes $4,000 $ 8,000 $ 12,000
Less: Taxes (T = 0.40) 1,600 3,200 4,800
Net profits after taxes $2,400 $4,800 $7,200
Less: Preferred stock dividends (PD) 2,400 2,400 2,400
Earnings available for common $ 0 $ 2,400 $ 4,800
(EAC)
Earnings per share (EPS) _$0__ = $0 _$2,400__ = $2.40 _$4,800__=$4.80
1,000 1,000 1,000

-100% +100%
aAs noted in Chapter 1, for accounting and tax purposes, interest is a tax-deductible expense, whereas
dividends must be paid from after-tax cash flows.

Case 1 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).

Case 2 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).

The effect of financial leverage is such that an increase in the firm’s EBIT results in a
more-than-proportional increase in the firm’s earnings per share, whereas a decrease
in the firm’s EBIT results in a more-than-proportional decrease in EPS.

Measuring the Degree of Financial Leverage (DFL)

The degree of financial leverage (DFL) is the numerical measure of the firm’s financial
leverage. Computing it is much like computing the degree of operating leverage. The
following equation presents one approach for obtaining the DFL.

DFL = Percentage change in EPS (3)

Percentage change in EBIT

Whenever the percentage change in EPS resulting from a given percentage change in
EBIT is greater than the percentage change in EBIT, financial leverage exists. This
means that whenever DFL is greater than 1, there is financial leverage.

Example
Applying Equation 3 to cases 1 and 2 in Table 4 yields

Case 1: +100% = 2.5

+40%

5
Case 2: -100% = 2.5
-40%

In both cases, the quotient is greater than 1, so financial leverage exists. The higher
this value, the greater the degree of financial leverage.

A more direct formula for calculating the degree of financial leverage at a base level of
EBIT is given by Equation 4, where the notation from Table 4 is used. Note that in the
denominator, the term 1/(1-T) converts the after-tax preferred stock dividend to a
before-tax amount for consistency with the other terms in the equation.

DFL at base level EBIT = ________EBIT_______ (4)

 1 
EBIT – I – PDX  
1 T 

Example
Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and the tax rate (T = 0.40) into
Equation 4 yields the following result:

$10,000
DFL at $10,000 EBIT =
 1 
$10,000  $2,000   $2,400 X 
 1  0.40 

$10,000
=  2.5
$4,000

Note that the formula given in Equation 4 provides a more direct method for calculating
the degree of financial leverage than the approach illustrated using Table 4 and
Equation 3.

Total Leverage
We also can assess the combined effect of operating and financial leverage on the
firm’s risk by using a framework similar to that used to develop the individual concepts
of leverage. This combined effect, or total leverage, can be defined as the potential
use of fixed costs, both operating and financial, to magnify the effect of changes in
sales on the firm’s earnings per share. Total leverage can therefore be viewed as the
total impact of the fixed costs in the firm’s operating and financial structure.

Example
Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per
unit in the coming year and must meet the following obligations: variable operating
costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000, and
preferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000
shares of common stock outstanding. Table 5 presents the levels of earnings per

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share associated with the expected sales of 20,000 units and with sales of 30,000
units.

Table 5
The Total Leverage Effect
+50%

Sales (in units) 20,000 30,000

Sales revenue a $100,000 $150,000

Less: Variable operating 40,000 60,000 DOL =
costs b +60% = 1.2
+50%
Less: Fixed operating costs 10,000 10,000
Earnings before interest
and taxes (EBIT) $ 50,000 $ 80,000

+60%
Less: Interest 20,000 20,000
Net profits before taxes $ 30,000 $ 60,000
Less: Taxes (T = 0.40) 12,000 24,000
Net profits after taxes $ 18,000 $ 36,000 DFL = DTL =
+300% = 5.0 +300% = 6.0
+60% +50%
Less: Preferred stock 12,000 12,000
dividends
Earnings available for $ 6,000 $ 24,000
common
Earnings per share (EPS) $6,000 = 1.20 $24,000
5,000 5,000
= $ 4.80

+300%
a Sales revenue = $5/unit X sales in units
b Variable operating costs = $2/unit x sales in units

This illustrates that as a result of a 50% increase in sales (from 20,000 to 30,000
units), the firm would experience a 300% increase in earnings per share (from $1.20 to
$4.80). Although it is not shown in the table, a 50% decrease in sales would,
conversely, result in a 300% decrease in earnings per share. The linear nature of the
leverage relationship accounts for the fact that sales changes of equal magnitude in
opposite directions result in EPS changes of equal magnitude in the corresponding
direction. At this point, it should be clear that whenever a firm has fixed costs –
operating or financial- in its structure, total leverage will exist.

Measuring the Degree of Total Leverage (DTL)

The degree of total leverage (DTL) is the numerical measure of the firm’s total
leverage. It can be computed much as operating and financial leverage are computed.
The following equation presents one approach for measuring DTL:

DTL = Percentage change in EPS (5)

Percentage change in sales

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Whenever the percentage change in EPS resulting from a given percentage change in
sales is greater than percentage change in sales, total leverage exists. This means
that as long as the DTL is greater than 1, there is total leverage.

Example
Applying Equation 5 to the data in Table 5 yields

DTL = +300% = 6.0

+50%

Because this result is greater than 1, total leverage exists. The higher the value, the
greater the degree of total leverage.

A more direct formula for calculating the degree of total leverage at a given base level
of sales, Q, is given by Equation 6, which uses the same notation that was presented
earlier:

QX ( P  VC )
DTL at base sales level Q = (6)
 1 
QX ( P  VC )  FC  I  ( PDX  
1 T 

Example
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000,
and the tax rate (T = 0.40) into Equation 12.9 yields

DTL at 20,000 units

20,000 X ($5  $2)

=
 1 
20,000 X ($5  $2)  $10,000  $20,000   $12,000 X 
 1  0.40 

$60,000
=  6.0
$10,000

Clearly, the formula used in Equation 12.9 provides a more direct method for
calculating the degree of total leverage than the approach illustrated using Table 5 and
Equation 5.

The Relationship of Operating, Financial, and Total Leverage

Total leverage reflects the combined impact of operating and financial leverage on the
firm. High operating leverage and high financial leverage will cause total leverage to be
high. The opposite will also be true. The relationship between operating leverage and
financial leverage is multiplicative rather than additive. The relationship between the
degree of total leverage (DTL) and the degrees of operating leverage (DOL) and
financial leverage (DFL) is given by Equation 7.

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 DTL = DOL X DFL (7)

Example
Substituting the values calculated for DOL and DFL, shown on the right-hand side of
Table 5, into Equation 7 yields

DTL = 1.2 X 5.0 = 6.0

The resulting degree of total leverage is the same value that we calculated directly in
the preceding examples.