Tài chính doanh nghiệp - Chapter 4: Measures of leverage

Chapter 4Measures of leveragePresenter’s namePresenter’s titledd Month yyyy1. IntroductionLeverage is the use of fixed costs in a company’s cost structure.Operating leverage relates to the company’s operating cost structure.Financial leverage relates to the company’s capital structure.Copyright © 2013 CFA Institute2Fixed CostsFixed CostsWhy worry about leverage?A company’s use of leverage affects its risk and return.Operating leverage and financial leverage provide insight into a company’s business and its future.Leverage helps us understand a company’s future cash flows and the risk associated with those cash flows and, hence, its valuation.Copyright © 2013 CFA Institute32. LeverageCopyright © 2013 CFA Institute4Leverage increases the volatility of earnings and cash flows → hence, it increases risk to suppliers of capital (creditors and owners).Consider two companies, Company One and Company Two, with the following information:Company OneCompany TwoNumber of units produced and sold1,0001,000Sales price per unit€250€250Variable cost per unit€125€25Fixed operating cost€50,000€100,000Fixed financing expense€5,000€55,000Debt€50,000€550,000Equity€700,000€200,000Total assets€750,000€750,000What does leverage do exactly?Copyright © 2013 CFA Institute5Company Two uses more operating and financial leverage than Company One.3. Business risk and financial riskBusiness risk is the risk associated with the volatility in operating earnings. Business risk is composed of both operating and sales risk.Sales risk is the uncertainty associated with the number of units produced and sold, as well as the sales price.Copyright © 2013 CFA Institute6Business RiskSales RiskOperating RiskOperating riskOperating risk is the risk associated with the mix of variable and fixed operating expenses.Operating risk is the sensitivity (i.e., elasticity) of operating earnings to changes in unit sales.The degree of operating leverage (DOL) is the ratio of the percentage change in operating income to the percentage change in units sold.The per unit contribution margin is the difference between the sales price and the variable cost per unit. This difference is available to cover fixed operating costs.Overall, for all units sold, the contribution margin is the difference between total revenues and variable operating costs.Copyright © 2013 CFA Institute7DOL Copyright © 2013 CFA Institute8Example: Company One and Company Two Copyright © 2013 CFA Institute9 Financial riskFinancial risk is the risk associated with the choice of financing the business.The greater the reliance on fixed-cost obligations, such as debt, the greater the financial risk.Similar to operating risk, financial risk elasticity is the sensitivity of income available to owners to a change in operating earnings.The degree of financial leverage (DFL) is the ratio of the percentage change in net income to the percentage change in operating income.Copyright © 2013 CFA Institute10DFL Copyright © 2013 CFA Institute11Example: Company One and Company TwoCopyright © 2013 CFA Institute12Company OneCompany TwoReturn on equity and the DFLThe greater the degree of financial leverage, the greater the financial risk.We can see the leveraging effect by looking at the return on equity (ROE) for different levels of units produced and sold.The greater the DFL, the more sensitive the ROE is to changes in the units produced and sold.Copyright © 2013 CFA Institute13Example: Return on equityConsider the example of Company One and Company Two:Copyright © 2013 CFA Institute14Degree of Total Leverage Copyright © 2013 CFA Institute15Example: Company One and Company TwoCopyright © 2013 CFA Institute16Company OneCompany TwoBreakeven Quantity Copyright © 2013 CFA Institute17Example: Company One and Company TwoCopyright © 2013 CFA Institute18Company OneCompany TwoRisks to creditors and ownersCopyright © 2013 CFA Institute19Business risk is affected by demand uncertainty, output price uncertainty, and cost uncertainty.Financial risk adds to the company’s business risk, increasing the risk to creditors and owners.The creditor claims are fixed, whereas the equity claims are residual.In the event that creditor claims cannot be satisfied, there may be legal statuses that help sort out the claims:Reorganization is the restructuring of claims, with the expectation that the company will be able to continue, in some form, as a going concern.Liquidation is the situation in which assets are sold and then the proceeds distributed to claimants. 4. SummaryLeverage is the use of fixed costs in a company’s cost structure. Business risk is the risk associated with operating earnings and reflectssales risk (uncertainty with respect to the price and quantity of sales) andoperating risk (the risk related to the use of fixed costs in operations). Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity and debt financing of the business).Copyright © 2013 CFA Institute20Summary (continued)The degree of operating leverage (DOL) is the sensitivity of operating earnings to changes in units produced and sold.The degree of financial leverage (DFL) is the sensitivity of cash flows to owners to changes in operating earnings.The degree of total leverage (DTL) is the sensitivity of the cash flows to owners to changes in unit sales.The breakeven point, QBE, is the number of units produced and sold at which the company’s net income is zero.The operating breakeven point, QOBE, is the number of units produced and sold at which the company’s operating income is zero.Copyright © 2013 CFA Institute21