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Leverage and Financial Risk in Business

Explore the impacts of leverage, business risk, and financial risk on earnings, with a focus on break-even analysis. Understand the dynamics of financial leverage and operating leverage to optimize profitability.

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Leverage and Financial Risk in Business

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  1. Financial Structure

  2. The Impact of Leverage • Business Risk • The variability in the earnings before interest and taxes • Financial Risk • The additional variability in the net income due to leverage Richard MacMinn

  3. Break-Even Analysis • Break-even Point • It is that quantity at which earnings before interest and taxes, EBIT, is zero • The earning before interest and taxes is EBIT = Revenue - (Variable Cost + Fixed Cost) = R – VC – F • Letting p, q, avc, and F represent price, quantity, average variable cost and fixed cost, respectively, the EBIT can also be represented as EBIT = p q - avc q - F = (p - avc) q - F Richard MacMinn

  4. Break-Even Analysis • The break-even point • Setting EBIT equalto zero and lettingb denote the break-even quantity, yields Richard MacMinn

  5. Break-Even Analysis • The break-even point is random if the firm’s sales are random. Richard MacMinn

  6. Break-Even Analysis • This slide shows how the cost and EBIT functions are affected by changes in the average variable cost. Richard MacMinn

  7. Break-Even Analysis • The break-even point can also be affected by changing the operating leverage, i.e., fixed cost. Richard MacMinn

  8. Business Risk • Leverage • The use of credit or borrowed funds to improve one's speculative capacity • Operating Leverage • This notion refers to the fixed cost in EBIT, independent of how it is financed. • Operating leverage is a business risk concept, i.e., as opposed to a financial risk concept. • In this case, the speculative capacity is that capacity that allows the firm to engage in risky business transactions on the chance of quick or considerable profit. Richard MacMinn

  9. Operating Leverage • The degree of operating leverage is denoted by DOL and defined asor as Richard MacMinn

  10. Observations The DOL is undefined at the break-even point. Operating leverage exists when DOL > 1. At sales levels above the break-even point, the DOL is a decreasing function of sales. The following figure provides a characterization of that decrease. Note that the slope of the EBIT function is p - avc while the slope of a chord from the origin to a point on the EBIT function is EBIT/q. Since the slope of the chord increases, the DOL decreases. Operating Leverage dollars R V + F EBIT c d quantity b Richard MacMinn

  11. Operating Leverage • Observations Richard MacMinn

  12. Financial Risk • Financial Leverage • This notion refers to the fixed costs due to debt issues • Financial leverage is a financial risk concept. • Degree of Financial Leverage (DFL) • The DFL is a measure of the responsiveness of shareholder returns to the EBIT. • The measure of shareholder returns used to determine eps is net income, NI. The NI is defined as NI = EBIT - I - T, where I represents interest on debt and T represents taxes. • NI = EBIT - I - t (EBIT - I) = (1 - t) (EBIT - I) • The DFL is defined as Richard MacMinn

  13. Financial Leverage • Alternate Representation • Observations • The DFL = 1 for the unlevered firm • The DFL is undefined for EBIT = I • The condition EBIT < I defines a financial distress event. • The DFL is greater than one and increasing in leverage for EBIT > I. • A larger DFL implies a larger fluctuation in NI and EPS. Richard MacMinn

  14. Degree of Financial Leverage • Note how the DFL measure changes with the interest expenses. Richard MacMinn

  15. Leverage • For the levered firm, a one percentage change in sales implies a larger percentage change in EBIT which in turn implies an even larger percentage change in NI and EPS. • The degree of combined leverage, DCL, is a measure designed to capture these percentage changes. It is defined as Richard MacMinn

  16. Leverage • Alternate Representation Richard MacMinn

  17. Leverage • Alternate Representationsince NI = (1 - t) (EBIT - I) = (1 - t) ((p - avc) q - F - I) and Richard MacMinn

  18. Leverage Observations • The DCL is undefined at the financial distress point f. • Leverage exists when DCL > 1. • At sales levels above the financial distress point, the DCL is a decreasing function of sales. • The following figure provides a characterization of that decrease. • Note that the slope of the NI function is (1 - t) (p - avc) while the slope of a chord from the origin to a point on the NI function is NI/q. Since the slope of the chord increases, the DCL decreases. dollars R V + F EBIT NI quantity f Richard MacMinn

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