Monday, October 24, 2011

Financial Leverage

CFA Level 1 - Corporate Finance

Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower.

As mentioned previously, financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.

Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT. This is known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

Formula 11.19

= percentage change in EPS or    EBIT       
  percentage change in EBIT    EBIT-interest

   A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be equal to 1.

Example: Degree of Financial LeverageWith Newco's current production, its sales are $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense amounts to $100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000-$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%.
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