Operating and Financial Leverage (part B)
by
Charles Lamson
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Financial Leverage
Having discussed the effects of fixed costs on the operations of the firm (operating leverage from last post), we now turn to the second form of leverage. Financial leverage reflects the amount of debt used in the capital structure of the firm. Because that carries a fixed obligation of interest payments, we have the opportunity to greatly magnify our results at various levels of operations. You may have heard of the real estate developer who borrows 100 percent of the costs of his project and will enjoy an infinite return on his zero investment if all goes well. It is helpful to think of operating leverage as primarily affecting the left-hand side of the balance sheet and financial leverage as affecting the right-hand side. 
Impact on Earnings In studying the impact of financial leverage, we shall examine two financial plans for a firm, each employing a significantly different amount of debt in the capital structure. Financing totaling $200,000 is required to carry the assets of the firm. The facts are presented below.  Under leveraged Plan A we will borrow $150,000 and sell 8,000 shares of stock at $6.25 to raise an additional $50,000, whereas conservative Plan B calls for borrowing only a $50,000 and acquiring an additional $150,000 in stock with 24,000 shares. In Table 5, we compute earnings per share for the two plans at various levels of "earnings before interest and taxes" (EBIT). These earnings (EBIT) represent the operating income of the firm before deductions have been made for financial charges or taxes. we assume (EBIT) levels of 0, $12,000, $16,000, $36,000, and $60,000. Table 5 Impact of financing plan on earnings per share  The impact of the two financing plans is dramatic. Although both plans assume the same operating income, or EBIT, for comparative purposes at each level say ($36,000 in calculation 4) the reported income per share is vastly different ($1.50 versus $0.67). it is also evident the conservative plan will produce better results at low income levels but the leverage plan will generate much better earnings per share as operating income, or EBIT, goes up. The firm would be indifferent between the two plans at an EBIT level of $16,000 as shown in Table 5. In figure 4 on page 124, we graphically demonstrate the effect of the two financing plans on earnings per share and the indifference point at an Abbot of 16 $1,000. With an Abbot of $16,000, we are earning 8% on total assets of $200,000 precisely the percentage cost of borrowed funds to the fern. The use or non-use of debt does not influence the answer. Beyond $16,000, plan a, employing heavy financial leverage, really goes to work, allowing the firm to greatly expand earnings per share as a result of a change in ebit. For example, at the ebit level of 36000, and 18% return on assets of $200,000 takes place and a financial leverage is clearly working to our benefit as earnings greatly expand.  Figure 4  Degree of Financial Leverage As was true of operating leverage, degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (EPS) that occurs as a result of a percentage change in earnings before interest and taxes (EBIT). Formula 4  For purposes of computation, the formula for DFL may be conveniently restated as: Formula 5  Let's compute the degrees of financial leverage for Plan A and plan B, previously presented in Table 5, at an EBIT level of $36,000. Plan A calls for $12,000 of interest at all levels of financing, and plan B requires $4,000. Plan A (Leveraged)  Plan B (Conservative)  As expected, Plan A has a much higher degree of financial leverage. At an EBIT level of $36,000, a 1 percent increase in earnings will produce a 1.5 earnings increase in earnings per share under Plan A, but only a 1.1 percent increase under Plan B. DFL may be computed for any level of operation, and it will change from point to point, but Plan A will always exceed Plan B.
Limitations to Use of Financial Leverage The alert readers of this blog may quickly observe that if debt is such a good thing, why sell any stock? With exclusive debt financing at an EBIT level of $36,000 we would have a degree of financial leverage factor DFL of 1.8.  (With no stock, we would borrow the full $200,000.)  As stressed throughout this analysis, debt financing and financial leverage offer unique advantages, but only up to a point---beyond that point, debt financing may be detrimental to the firm. For example, as we expand the use of debt in our capital structure, lenders will perceive a greater financial risk for the firm. For that reason, they may raise the average interest rate to be paid and they may demand that certain restrictions be placed on the corporation. Furthermore, concerned common stockholders may drive down the price of the stock---forcing us away from the objective of maximizing the firm's overall value in the market. The impact of financial leverage must be carefully weighed by firms with high debt. This is not to say that financial leverage does not work to the benefit of the firm---it does if properly used. Further discussion of appropriate debt-equity mixes is covered in later posts. For now, we accept the virtues of financial leverage, knowing that all good things must be used in moderation. For firms that are in industries that offer some degree of stability, are in a positive stage of growth, and are operating in favorable economic conditions, the use of debt is recommended. *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 121-125* end |
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