Principles of Managerial Finance

Fifteenth Edition, Global Edition

Chapter 13
Leverage and Capital Structure

Copyright © 2019 Pearson Education, Ltd. All Rights Reserved.

Learning Goals (1 of 2)
LG 1 Discuss leverage, capital structure, breakeven analysis, the
operating breakeven point, and the effect of changing costs on
the breakeven point.
LG 2 Understand operating, financial, and total leverage and the
relationships among them.
13.1 Breakeven Analysis

• Breakeven Analysis
• Used to determine the level of operations necessary to cover all costs and to
evaluate the profitability associated with various levels of sales; also called
cost-volume-profit analysis
• Operating Breakeven Point
• The level of sales necessary to cover all operating costs; the point at which
EBIT( operating income ) = $0
Break-Even Chart: Leveraged Firm
From the above we conclude the following:
• 1- The break-even quantity is achieved when total revenue = total
costs, (at the amount of sales of 50,000 units).

• 2- Before the break-even point, the company makes a loss because

total costs > total revenue.

• 3- After the break-even point, the company makes profits because

total costs < total revenue.
Break-Even Analysis
• The break-even point is at 50,000 units, where the total costs and
total revenue lines intersect
Units = 50,000 .

Total Variable Fixed Costs Total Costs Total Revenue Operating Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0
Break-Even Analysis (cont’d)
• The break-even point can also be calculated by:

Fixed costs = Fixed costs = FC

Contribution margin Price – Variable cost per unit P – VC

i.e. $60,000 = $60,000 = 50,000 units

$2.00 - $0.80 $1.20
Volume-Cost-Profit Analysis: Leveraged Firm
Table 5-2
Figure 13.1 Breakeven Analysis
Example 13.1
Assume that Cheryl’s Posters, a small poster retailer,
has fixed operating costs of $2,500. Its sale price is $10
per poster, and its variable operating cost is $5 per
poster. Applying Equation 13.3 to these data yields
$2,500 $2,500
Q   500 units
$10  $5 $5
At sales of 500 units, the firm’s EBIT should just equal
$0. The firm will have positive EBIT for sales greater
than 500 units and negative EBIT, or a loss, for sales less
than 500 units. We can confirm this conclusion by
substituting values above and below 500 units, along
with the other values given, into Equation 13.1.
Table 13.3 Sensitivity of Operating Breakeven Point
to Increases in Key Breakeven Variables
Increase in variable Effect on operating breakeven point

Fixed operating cost (FC) Increase

Sale price per unit (P) Decrease

Variable operating cost per unit (VC) Increase

Note: Decreases in each of the variables shown would have the opposite effect on the operating breakeven point.
Example 13.2 (1 of 2)
Assume that Cheryl’s Posters wishes to evaluate the impact
of several options: (1) increasing fixed operating costs to
$3,000; (2) increasing the sale price per unit to $12.50; (3)
increasing the variable operating cost per unit to $7.50; and
(4) simultaneously implementing all three of these changes.
Substituting the appropriate data into Equation 13.3 yields
 $3,000
(1) Operating breakeven point   600 units
$10  $5
$2,500
(2) Operating breakeven point   333 13 units
$12.50  $5
$2,500
(3) Operating breakeven point   1,000 units
$10  $7.50
$3,000
(4) Operating breakeven point   600 units
$12.50  $7.50
What is Leverage?
• Use of special forces and effects to magnify or produce more than
normal results from a given course of action
• Can produce beneficial results in favorable conditions
• Can produce highly negative results in unfavorable conditions
13.1 Leverage (1 of 17)
• Leverage
• Refers to the effects that fixed costs have on the returns that shareholders
earn; higher leverage generally results in higher but more volatile returns
• Operating Leverage
• Relates to the relationship between the firm’s sales revenue and its earnings
before interest and taxes (EBIT) or operating profit
• Financial Leverage
• Relates to the relationship between the firm’s EBIT and its common stock
earnings per share (EPS)
13.1 Leverage (2 of 17)
• Total Leverage
• The combined effect of operating and financial leverage
• It relates to the relationship between the firm’s sales revenue and EPS
• Capital Structure
• The mix of long-term debt and equity maintained by a firm
13.1 Leverage (8 of 17)
• Operating Leverage
• The use of fixed operating costs to magnify the effects
of changes in sales on the firm’s earnings before interest
and taxes

• Fixed Costs and Operating Leverage

• Changes in fixed operating costs affect operating leverage
significantly
• Firms sometimes can alter the mix of fixed and variable costs
in their operations
13.1 Leverage (9 of 17)
• Operating Leverage
• Measuring the Degree of Operating Leverage (DOL)
• Degree of Operating Leverage (DOL)
• The numerical measure of the firm’s operating leverage

Q  ( P  VC )
DOL at base sales level Q  (13.5)
Q  ( P  VC )  FC
Example : For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80,
and FC = $60,000:

DOL = 80,000 ($2.00 - $0.80) ;

80,000 ($2.00 - $0.80) - $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) - $60,000 $96,000 - $60,000
DOL = 2.7

This means that a 1% increase in sales results in an increase in operating profit by

2.7%.
Example : For the leveraged firm, assume Q = 40,000, with P = $2, VC = $0.80,
and FC = $60,000:

DOL = 40,000 ($2.00 - $0.80) ;

40,000 ($2.00 - $0.80) - $60,000
= 40,000 ($1.20) = $48,000 ;
80,000 ($1.20) - $60,000 $48,000 - $60,000
DOL = - 4

This means that a 1% decrease in sales results in an decrease in operating profit by

4%.
Example : For the leveraged firm, assume Q = 50,000, with P = $2, VC = $0.80,
and FC = $60,000:

DOL = 50,000 ($2.00 - $0.80) ;

50,000 ($2.00 - $0.80) - $60,000
= 50,000 ($1.20) = $60,000 ;
80,000 ($1.20) - $60,000 $60,000 - $60,000
DOL = indefinite value
Continuous
• 4- Operating leverage is negative when the sales quantity is less than
the break-even quantity.

• 5- Operating leverage is positive when the sales quantity is greater

than the break-even quantity.

• 6- The operating leverage is an indefinite value when the sales

quantity equals the break-even quantity.
Second method to calculate DOL

DOL = Sales revenue – variable cost

EEEBIT
E EBIT
13.1 Leverage (11 of 17)
• Financial Leverage
• The use of fixed financial costs to magnify the effects of changes in earnings
before interest and taxes on the firm’s earnings per share
• The two most common fixed financial costs are
1) interest on debt
2) preferred stock dividends
• Firms must pay these expenses regardless of the amount of EBIT available to
pay them
13.1 Leverage (13 of 17)
• Financial Leverage
• Measuring the Degree of Financial Leverage
• Degree of Financial Leverage
• A more direct formula for calculating the degree of financial leverage
at a base level of EBIT is given by:

EBIT
DFL at base Level EBIT  (13.7)
 1 
EBIT  I   PD  
 1 T 

Where PD is the preferred stock dividend.

Example 13.11
Entering EBIT = $10,000, I = $1,400, PD = $2,400, and the
tax rate (T = 0.21) from Table 13.6 into Equation 13.7 yields

$10, 000
DFL at $10,000 EBIT 
 1 
$10, 000  $1, 400   $2, 400  
 1  0.21 
$10, 000
  1.8
$5,562
13.1 Leverage (12 of 17)
• Financial Leverage
• Measuring the Degree of Financial Leverage
• Degree of Financial Leverage
• The numerical measure of the firm’s financial leverage

Percentage change in EPS

DFL= (13.6)
Percentage change in EBIT
13.1 Leverage (14 of 17)
• 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
Combining Operating
and Financial Leverage
• Combined leverage: when both leverages allow a firm to maximize
returns
• Operating leverage:
• Affects the asset structure of the firm
• Determines the return from operations
• Financial leverage:
• Affects the debt-equity mix
• Determines how the benefits received will be allocated
13.1 Leverage (17 of 17)
• Total Leverage
• Relationship of Operating, Financial, and Total Leverage
• Total leverage reflects the combined impact of operating and financial leverage on the
firm
• High operating leverage and high financial leverage will cause total leverage to be high
• The opposite will also be true
• The relationship between operating leverage and financial leverage is multiplicative
rather than additive
• The relationship between the degree of total leverage (DTL) and the degrees of
operating leverage (DOL) and financial leverage (DFL) is given by:
DTL = DOL × DFL (13.10)
Table 13.1 General Income Statement Format
and Types of Leverage
13.1 Leverage (16 of 17)
• Total Leverage
• Measuring the Degree of Total Leverage (DTL)
• Degree of Total Leverage
• A more direct formula for calculating the degree of total leverage at a
given base level of sales

Q  ( P  VC )
DTL at base sales level  (13.9)
 1 
Q  ( P  VC )  FC  I   PD  
 1 T 
Example 13.14
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000,
I = $20,000, PD = $12,000, and the tax rate (T = 0.21)
Calculate DOL , DFL and DTL at 20,000 units
Solution
DOL = 20,000X ($5- $2) = 1.2
20,000($5 - $2 ) – 10,000
DFL= 20,000($5 - $2 ) – 10,000
20,000($5 - $2 ) – 10,000- 20,000- (12,000X 1
)
(1-0.21)
DFL =3.4
DTL = 1.2 × 3.4 = 4.1
Third method to calculate DOL

Percentage change in EBIT

DOL= (13.4)
Percentage change in sales
Third method to calculate DFL
• Financial Leverage
• Measuring the Degree of Financial Leverage
• Degree of Financial Leverage
• The numerical measure of the firm’s financial leverage

Percentage change in EPS

DFL= (13.6)
Percentage change in EBIT
Third method to calculate DTL
• Total Leverage
• Measuring the Degree of Total Leverage (DTL)
• Degree of Total Leverage
• The numerical measure of the firm’s total leverage

Percentage change in EPS

DTL= (13.8)
Percentage change in sales
Table 13.7 The Total Leverage Effect