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6 Degree of Leverages

This document discusses leverage in business and finance. It defines leverage as the effects that fixed costs have on shareholder returns. It also differentiates between business risk, which depends on factors like demand variability, and financial risk, which refers to the risk of bankruptcy. The document then discusses operating leverage, financial leverage, and total leverage. It provides formulas to calculate the degree of operating, financial, and total leverage. Finally, it gives an example calculating these values for a company called Mokona.

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Jennalyn Damaso
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108 views5 pages

6 Degree of Leverages

This document discusses leverage in business and finance. It defines leverage as the effects that fixed costs have on shareholder returns. It also differentiates between business risk, which depends on factors like demand variability, and financial risk, which refers to the risk of bankruptcy. The document then discusses operating leverage, financial leverage, and total leverage. It provides formulas to calculate the degree of operating, financial, and total leverage. Finally, it gives an example calculating these values for a company called Mokona.

Uploaded by

Jennalyn Damaso
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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TOPIC 6: DEGREE OF LEVERAGE

Topic Learning Outcomes


After this topic, you should be able to:
1. Understand concept and application of leverage in business.
2. Differentiate Business and Financial Risk.
3. Discuss and compute the firm’s operating leverage.
4. Discuss and compute the firm’s financial leverage.
5. Discuss and compute the firm’s combined or total leverage.
6. Interpret the firm’s degree of financial, operating, and combined or total leverage.
7. Explain the impact of combining operating leverage and financial leverage for the firm.

Be Engaged
Look:

https://www.google.com/url?sa=i&url=https%3A%2F%2Feschooltoday.com%2Fscience%2Fsimple-machines%2Fwhat-is-a-
lever.html&psig=AOvVaw1cbe4teXyjMfMJj3sUBS_m&ust=1595036168459000&source=images&cd=vfe&ved=0CAIQjRxqFwoTCJjKtoaT0-oCFQAAAAAdAAAAABAD

Think:
1. Base on your basic knowledge in science, what do you call the simple machine that is illustrated above?
Can you name other objects that possess the characteristic of this simple machine?
2. How do you think this object helps us in our daily lives?
3. Do you think that the mechanism behind this simple machine can be applied in finance? Why or why
not?

BAFIMARX – Topic 6 1
Let’s Discuss
1. Definition of Leverage
2. Difference of Business and Financial Risk
3. Operating Leverage
4. Measuring Degree of Operating Leverage
5. Financial Leverage
6. Measuring Degree of Financial Leverage
7. Total or Combined Leverage
8. Measuring Degree of Total or Combined Leverage
9. Relationship of Operating, Financial, and Total Leverage

Leverage
• the effects that fixed costs have on the returns that shareholders earn
• higher leverage generally results in higher but more volatile returns
• also refers to a particular cost or expense that is used to generate profit or income to the company.

Evaluation of Business and Financial Risk


Business risk
• The riskiness inherent in the firm’s operations if it uses no debt.
• These depends on several factors such as
1. Product obsolescence
2. Foreign risk exposure
3. Demand variability.
4. Sales price variability
5. Regulatory risk and legal exposure
6. The extent to which costs are fixed: operating leverage
7. Competition.
8. Input cost variability

Operating Leverage
• represents extent of the use of fixed operating costs to magnify the effects of changes in sales on the
firm’s earnings before interest and taxes.
• the risk that the result of the firm’s operation may not be able to cover the fixed cost it incurred.

Degree of Operating Leverage (DOL)


• Used as a measurement of Operating Leverage
• Formula:
𝐶𝑀 %Δ𝐸𝐵𝐼𝑇
o 𝐷𝑂𝐿 = 𝐸𝐵𝐼𝑇 𝑜𝑟 %Δ𝑆𝑎𝑙𝑒𝑠

BAFIMARX – Topic 6 2
Financial Risk
• the additional risk placed on the common stockholders because of the decision to finance with debt
• may also refer to the risk that the company may not be able to settle its liabilities and may go
bankrupt.

Financial Leverage
• The extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital
structure
• the use of debt concentrates the firm’s business risk on the stockholders

degree of financial leverage (DFL)


• The numerical measure of the firm’s financial leverage.
• Formula:
𝐸𝐵𝐼𝑇 %Δ𝑁𝐼
o 𝐷𝐹𝐿 = 𝑜𝑟
𝐸𝐵𝑇 %Δ𝐸𝐵𝐼𝑇

Total or Combined Risk


• Represents the combined risk borne by the firm because of using fixed cost and financing.

TOTAL LEVERAGE
• The use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the
firm’s earnings per share.

degree of total or combined leverage (DTL)


• represents the extent to which both the fixed cost and interest expenses are incurred
• this is the numerical measure of the firm’s total leverage.
• Formula:
𝐶𝑀 %Δ𝑁𝐼
o 𝐷𝑇𝐿 = 𝑜𝑟
𝐸𝐵𝑇 %Δ𝑆𝑎𝑙𝑒𝑠

Relationship of Operating, Financial, and Total Leverage


The relationship between operating leverage and financial leverage is multiplicative rather than additive.
This relationship is expressed by:

Application of Degree of Leverages:


Mokona has the following forecast for 2020:
Forecast sales in units 50,000.00
Sales price per unit ₱ 40.00
Variable cost per unit ₱ 25.00
Fixed cost:
Manufacturing overhead and expenses ₱ 300,000.00
Interest expenses ₱ 25,000.00

BAFIMARX – Topic 6 3
a. How much is the Earnings before interest and taxes? 450,000
b. How much is the Earnings after interest and taxes? 425,000
c. What is the Degree of Operating Leverage at 50,000 units? 1.67
d. What is the Degree of Financial Leverage at 50,000 units? 1.06
e. What is the Degree of Total or Combined Leverage at 50,000 units? 1.76

Solution:
Sales ₱ 2,000,000.00
Variable Cost ₱ 1,250,000.00
Contribution Margin ₱ 750,000.00
Fixed Cost ₱ 300,000.00
EBIT ₱ 450,000.00
Interest ₱ 25,000.00
Taxes 0
EBT ₱ 425,000.00

₱ 750,000.00
DOL = = 1.67
₱ 450,000.00

₱ 450,000.00
DFL = = 1.06
₱ 425,000.00

₱ 750,000.00
DTL = = 1.76 Or 1.67 * 1.06 = 1.76
₱ 425,000.00

BAFIMARX – Topic 6 4
References
• Gitman, L. J., & Zutter, C. J. (2015). Principles of Managerial Finance. Pearson Education Limited.
• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengege.
• Bagayao, I. Y., & et al. (n.d.). Financial Management Volume 1.
• Bagayao, I. S., & et al. (n.d.). Financial Management Volume 2.

Other online resources


Degree of financial leverage
https://corporatefinanceinstitute.com/resources/knowledge/finance/degree-of-financial-leverage/
https://www.youtube.com/watch?v=GESzfA9odgE

Degree of total leverage


https://corporatefinanceinstitute.com/resources/knowledge/finance/degree-of-total-leverage/
https://www.accountingtools.com/articles/2017/5/6/degree-of-total-leverage
https://www.youtube.com/watch?v=5gbIJpeohcM

BAFIMARX – Topic 6 5

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