Corporate Finance - Measures of Leverage

5:30 pm

Measures of Leverage
Reading 38 in CFAI materials

Intro

• Leverage is use of fixed costs in a company's cost structure
• High operating costs = operating leverage
• High financial costs = financial leverage
• Leverage can magnify earnings both up and down
• Helps assess risk/return, interpret mgmt signals, and in valuation/discount rate selection

Greater leverage, greater risk, and greater discount rate should be applied

• Cost structures have fixed and variable components
• Risk can be very different for two companies with the same net income
• Variability in net income is higher for more levered companies

Components of risk

• Revenue risk, economy, competition, etc - 'sales' risk (uncertainty wrt price/quantity of goods sold)
• As illustrated by standard deviations of unit sales prices
• Operating risk - cost structure risk, esp fixed costs.   
• Greater fixed to variable, greater operating risk
• Degree of Operating Leverage - measure of elasticity of income to sales
• DOL = %change in operating income / %change in units sold
• This changes for different unit sales levels
• Another form:
• DOL = [Q * (P - V)] / [Q * (P - V) - F]
• Business risk = sales risk + operating risk

Operating Risk

• Operating income = number of units * per unit contribution margin - fixed operating costs
• In practice you don't have a clean breakdown of fixed and variable
• You can regress changes in operating income on changes in revenue
• Higher coefficient = higher operating leverage

Financial Risk

• Risk of a security is affected by both business risk and financial risk
• Financial risk is a product of taking on debt
• Degree of Financial Leverage:
• DFL = %change in net income / %change in operating income
• DFL = [Q * (P - V) - F] / [Q * (P - V) - F - C]
• DFL is NOT affected by tax rate - it cancels out of the equation
• Also different at different levels of income
• DFL is usually a choice of management (unlike DOL)
• Companies with high ratios of tangible assets to total assets might be able to use more leverage

Total Leverage

• Combined effect of operating and financial leverage
• Degree of Total Leverage
• DTL = %change in net income / %change in number of units sold
• DTL = DOL * DFL
• DTL = [Q * (P-V)] / [Q * (P-V) - F - C]

Breakeven Points

• Quantity where total revenues = total costs
• PQ = VQ + F + C
• Qbreakeven = (F + C) / (P - V)
• Operating preakeven point
• Rather than net income, can exclude financing costs
• PQ = VQ + F
• Qbreakeven = F / (P - V)

Risks of Creditors and Owners

• Lenders have a prior claim over investors - higher security but lower returns
• Equity owners may get a lot, or may get nothing
• Get right to hire, fire, and guide managers
• Chapter 11 and liquidation - difference between the two is often difference between financial and operating leverage
• High operating leverage can't be fixed in bankruptcy
• High financial leverage can be alleviated by changing capital structure

End

6:30 pm

1 hour