CHAPTER 4 MEASURES OF LEVERAGE Presenter’s name Presenter’s title dd Month yyyy

1. INTRODUCTION Leverage is the use of fixed costs in a company’s cost structure. -Operating leverage relates to the company’s operating cost structure. -Financial leverage relates to the company’s capital structure. Copyright © 2013 CFA Institute 2 Fixed Costs

WHY WORRY ABOUT LEVERAGE? 1.A company’s use of leverage affects its risk and return. 2.Operating leverage and financial leverage provide insight into a company’s business and its future. 3.Leverage helps us understand a company’s future cash flows and the risk associated with those cash flows and, hence, its valuation. Copyright © 2013 CFA Institute 3

2. LEVERAGE Copyright © 2013 CFA Institute 4 Leverage increases the volatility of earnings and cash flows → hence, it increases risk to suppliers of capital (creditors and owners). Consider two companies, Company One and Company Two, with the following information: Company One Company Two Number of units produced and sold1,000 Sales price per unit€250 Variable cost per unit€125€25 Fixed operating cost€50,000€100,000 Fixed financing expense€5,000€55,000 Debt€50,000€550,000 Equity€700,000€200,000 Total assets€750,000

WHAT DOES LEVERAGE DO EXACTLY? Copyright © 2013 CFA Institute 5 Company Two uses more operating and financial leverage than Company One.

3. BUSINESS RISK AND FINANCIAL RISK Business risk is the risk associated with the volatility in operating earnings. -Business risk is composed of both operating and sales risk. Sales risk is the uncertainty associated with the number of units produced and sold, as well as the sales price. Copyright © 2013 CFA Institute 6 Business Risk Sales Risk Operatin g Risk

OPERATING RISK Operating risk is the risk associated with the mix of variable and fixed operating expenses. -Operating risk is the sensitivity (i.e., elasticity) of operating earnings to changes in unit sales. The degree of operating leverage (DOL) is the ratio of the percentage change in operating income to the percentage change in units sold. The per unit contribution margin is the difference between the sales price and the variable cost per unit. This difference is available to cover fixed operating costs. -Overall, for all units sold, the contribution margin is the difference between total revenues and variable operating costs. Copyright © 2013 CFA Institute 7

DOL Copyright © 2013 CFA Institute 8

EXAMPLE: COMPANY ONE AND COMPANY TWO Copyright © 2013 CFA Institute 9

FINANCIAL RISK Financial risk is the risk associated with the choice of financing the business. -The greater the reliance on fixed-cost obligations, such as debt, the greater the financial risk. -Similar to operating risk, financial risk elasticity is the sensitivity of income available to owners to a change in operating earnings. The degree of financial leverage (DFL) is the ratio of the percentage change in net income to the percentage change in operating income. Copyright © 2013 CFA Institute 10

DFL Copyright © 2013 CFA Institute 11

EXAMPLE: COMPANY ONE AND COMPANY TWO Copyright © 2013 CFA Institute 12 Company One Company Two

RETURN ON EQUITY AND THE DFL The greater the degree of financial leverage, the greater the financial risk. We can see the leveraging effect by looking at the return on equity (ROE) for different levels of units produced and sold. The greater the DFL, the more sensitive the ROE is to changes in the units produced and sold. Copyright © 2013 CFA Institute 13

EXAMPLE: RETURN ON EQUITY Consider the example of Company One and Company Two: Copyright © 2013 CFA Institute 14

DEGREE OF TOTAL LEVERAGE Copyright © 2013 CFA Institute 15

EXAMPLE: COMPANY ONE AND COMPANY TWO Copyright © 2013 CFA Institute 16 Company One Company Two

BREAKEVEN QUANTITY Copyright © 2013 CFA Institute 17

EXAMPLE: COMPANY ONE AND COMPANY TWO Copyright © 2013 CFA Institute 18 Company One Company Two

RISKS TO CREDITORS AND OWNERS Copyright © 2013 CFA Institute 19 Business risk is affected by demand uncertainty, output price uncertainty, and cost uncertainty. Financial risk adds to the company’s business risk, increasing the risk to creditors and owners. The creditor claims are fixed, whereas the equity claims are residual. In the event that creditor claims cannot be satisfied, there may be legal statuses that help sort out the claims: -Reorganization is the restructuring of claims, with the expectation that the company will be able to continue, in some form, as a going concern. -Liquidation is the situation in which assets are sold and then the proceeds distributed to claimants.

4. SUMMARY Leverage is the use of fixed costs in a company’s cost structure. Business risk is the risk associated with operating earnings and reflects -sales risk (uncertainty with respect to the price and quantity of sales) and -operating risk (the risk related to the use of fixed costs in operations). Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity and debt financing of the business). Copyright © 2013 CFA Institute 20

SUMMARY (CONTINUED) The degree of operating leverage (DOL) is the sensitivity of operating earnings to changes in units produced and sold. The degree of financial leverage (DFL) is the sensitivity of cash flows to owners to changes in operating earnings. The degree of total leverage (DTL) is the sensitivity of the cash flows to owners to changes in unit sales. The breakeven point, Q BE, is the number of units produced and sold at which the company’s net income is zero. The operating breakeven point, Q OBE, is the number of units produced and sold at which the company’s operating income is zero. Copyright © 2013 CFA Institute 21