1. Leverage and Capital Structure-Part 1
Chapter 7
Leverage and Capital Structure-Part 1

2. 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 increases in risk and return, whereas decreases in leverage result in decreases in risk and return.
The amount of leverage in the firm’s capital structure— the mix of debt and equity—can significantly affect its value by affecting risk and return.
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3. 3 basis types of leverage
Operating leverage-concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes.
Financial Leverage-concerned with the relationship between the firm’s EBIT and its earnings per share
Total leverage-concerned with the relationship between the firm’s sales revenue and EPS.
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4. Leverage (cont.)
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5. Breakeven Analysis
Breakeven (cost-volume-profit) analysis is used by the firm to:
determine the level of operations necessary to cover all operating costs, and
evaluate the profitability associated with various levels of sales.
The firm’s operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses.
At the OBP, operating profit (EBIT) is equal to zero.
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6. Breakeven Analysis (cont.)
To calculate the OBP, cost of goods sold and operating expenses must be categorized as fixed or variable.
Variable costs vary directly with the level of sales and are a function of volume, not time.
Examples would include direct labor and shipping costs.
Fixed costs are a function of time and do not vary with sales volume.
Examples would include rent and fixed overhead.
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7. Breakeven quantity= FC P-VC
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8. OPERATING LEVERAGE
Operating leverage results from the existence of fixed operating costs in the firm’s income stream. Operating leverage can be defined 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.
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9. Operating Leverage (cont.)
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10. Operating Leverage: Measuring the Degree of Operating Leverage
The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales.
A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL.
Only companies that use fixed costs in the production process will experience operating leverage.
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11. Operating Leverage: Measuring the Degree of Operating Leverage (cont)
DOL = Percentage change in EBIT
Percentage change in Sales
Applying this equation to cases 1 and 2 in Table 12.4 yields:
Case 1: DOL = (+100% ÷ +50%) = 2.0
Case 2: DOL = (-100% ÷ -50%) = 2.0
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