MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Leverage Firms can raise money through a variety of means. Usually, money is raised through the issuance of different types of securities (such as stocks and bonds). The capital structure of a firm is the proportion of each type of security that the firm has used. Most firms have both debt and equity in their capital structure. In general, debt is referred to as leverage and firms with debt in their capital structure are levered. Because firms have debt, we can divide the risk of owning a stock into two parts: 1) Business (or Operating) Risk: This is the risk associated with the assets of the company. In other words, it is the risk involved in the business activities of the firm. If the firm were 100% equity financed, this would be the only risk in the companies stock. 2) Financial Risk: When a firm is levered, its stock will have more risk. This derives from the fact that holders of the debt of the firm must be paid their interest before the stockholders can receive anything (i.e. dividends). Because of financial risk, the beta of a stock of a levered company will be greater than the stock of an identical, but unlevered, company. Example: Consider two firms with identical operations. Each has raised $1,000,000 in financing. Firm A financed 100% with equity (sold 100,000 shares at $10 each). Firm B financed with $500,000 in debt (at 10% interest) and sold 50,000 shares at $10 each.
Three possible outcomes for next year, depending on the economy: Firm A: EBIT Interest Taxable Income Tax (@ 40%) Net Income Return on Equity EPS Recession $50,000 0 50,000 20,000 $30,000 3% $0.30 Average $200,000 0 200,000 80,000 $120,000 12% $1.20 Boom $350,000 0 350,000 140,000 $210,000 21% $2.10

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Firm B: EBIT Interest Taxable Income Tax (@ 40%) Net Income Return on Equity EPS Recession $50,000 50,000 0 0 $0 0 $0 Average $200,000 50,000 150,000 60,000 $90,000 18% $1.80 Boom $350,000 50,000 300,000 120,000 $180,000 36% $3.60

The variability in EBIT is the same for both firms (they have the same business risk), but EPS are much more variable for firm B. Firm B is leveraged, it has more financial risk. Note: Assume that the three possible outcomes are equally likely (each has 1/3 probability) Expected EPS for A = (1/3)(0.30) +(1/3)(1.20) + (1/3)(2.10) = $1.20 Expected EPS for B = (1/3)(0) +(1/3)(1.80) + (1/3)(3.60) = $1.80 Leverage increases the expected earnings per share (and the expected return on equity). Leverage increases the expected return to shareholders, but also the risk.

Note that the numbers of interest to the shareholders of these firms, the Return on Equity and the Earnings per Share, are more variable for the levered firm than for the unlevered firm. Thus, the levered firm is more risky. This illustrates the point that, while people often think of leverage creating risk simply because it raises the possibility of bankruptcy, leverage increases the risk of the stock of a company even if that company is very healthy and there is very little chance of it going bankrupt. The beta of a stock can be thought of as consisting of two parts, the part associated with business risk (which I will denote asset because it deals with the risk of the assets of the firm), and the part associated with the financial risk of the firm. If the firm is 100% equity financed, asset=equity where: equity is the beta of the stock of the firm (from CAPM). If the firm is levered: asset<equity

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Determinants of Beta The beta of a stock is not determined through magic. There are underlying factors in each firm that help determine what the beta of that stock will be. There are, of course, an immense number of details about a firm that contribute to its overall risk level. However, there are three main factors that determine beta: 1) Cyclicity 2) Operating Leverage 3) Financial Leverage 1) Cyclicity: Some firms have profit streams that tend to be very cyclical. They tend to do very well when the economy is expanding and very poorly when the economy is in recession. These stocks tend to be high beta stocks. Firms whose profits are fairly constant throughout the business cycle tend to be low beta stocks. Cyclicity of profits is a contributor to business risk. 2) Operating Leverage: This has to do with the relative levels of fixed and variable costs in the firms production process. Example: A firm can choose between two different methods for production. Method A Fixed Costs: $1000/year Variable Costs: $8/unit Price: $10/unit Contribution Margin: $2 Method B $2000/year $6/unit $10/unit $4

where: Contribution margin is defined as the difference between price and variable cost. Because Method B has lower variable costs and higher fixed costs, it is said to have more operating leverage. Operating leverage contributes to the business risk of the firm because it amplifies the effects of cyclicity. For example, suppose you unexpectedly lose a sale; with Method A you lose $2 in profit, while with Method B you $4 in profit. More operating leverage means more business risk (and therefore a higher beta for the firms stock). 3) Financial Leverage: This is the borrowing done by the firm. A highly leveraged firm will have more financial risk and therefore a higher beta.

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Measuring Leverage Explicitly Because the degree of leverage (both operating and financial) that a firm has a great deal of influence on its riskiness, it would be nice to have a precise way to measure how levered a firm is. Start with financial leverage: Degree of Financial Leverage - need a way to measure the degree of financial leverage (DFL) that a firm has - cannot just use the amount of debt, because firms are of different sizes, average level of EBIT et cetera. Thus, a lot of debt for a small firm might be only a little debt for a large firm. - DFL determines how variability in EBIT translates into variability in EPS. - use this to measure the firms DFL
DFL = percentage change in EPS percentage change in EBIT

Example: Use numbers from last handout. Use EBIT = $200,000 as a base. Firm A:
DFL A ,200000

2.10 1.20 1.20 = 350000 200000 200000 0.75 = 0.75 =1

Thus, a 1% rise in EBIT from $200,000 will give a 1% rise in EPS. The one-to-one relationship is because there is no leverage. DFL = 1 indicates no effect of financial leverage.

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Firm B:
DFL b,200000

3.60 180 . 180 . = 350000 200000 200000 1 = 0.75 = 1.33

Thus, a 1% rise in EBIT from $200,000 will give a 1.33% rise in EPS DFLB>DFLA B has more financial leverage. Easier way to calculate DFL; Consider a $1 change in EBIT. Percentage change in EBIT=1/EBIT Let I=interest, T= tax rate, S = number of shares
EPS = ( EBIT I)(1 T) S

$1 change in EBIT gives;

( EBIT + 1 I)(1 T) ( EBIT I )(1 T) S S Percentage change in EPS = ( EBIT I )(1 T) S

To get DFL, divide the percentage change in EPS by the percentage change in EBIT, and with some simple algebra you will get:

DFL =

EBIT EBIT I

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

Degree of Operating Leverage Consider two firms which produce an identical product, but utilize different production technologies. Firm A uses a labour intensive process. It has fixed costs of $100,000 per year and its variable costs are $3 per unit produced. Firm B uses a more automated system. Its fixed costs are $150,000 per year and it has variable costs of $2 per unit produced. Both firms sell their at a price of $10 per unit. Sales next year depend on the state of the economy, which could be recession, average or expansion. Firm A: Unit sales Sales fixed cost variable costs EBIT Firm B: Unit sales Sales fixed cost variable costs EBIT 20,000 200,000 100,000 60,000 40,000 20,000 200,000 150,000 40,000 10,000 50,000 500,000 100,000 150,000 250,000 50,000 500,000 150,000 100,000 250,000 100,000 1,000,000 100,000 300,000 600,000 100,000 1,000,000 150,000 200,000 650,000

Both firms have the same degree of risk (variability) in their level of sales. However, firm B has higher variability in its EBIT. Hence, B has more business risk. The greater risk in B is because of the higher operating leverage, a greater proportion of fixed costs. The degree of operating leverage (DOL) determines how risk in sales translates in to risk in EBIT (business risk). [The DFL then determines how risk in EBIT translates into risk in EPS.] How to measure DOL?
DOL = percentage change in EBIT percentage change in sales

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

From the above numbers:

600000 250000 250000 = 1000000 500000 500000 1.4 = 1 = 1.4 650000 250000 250000 = 1000000 500000 500000 = 1.6

DOL

A, 500000

DOL B , 500000

As with DFL, there is an easier way to calculate DOL. By considering a $1 change in sales and doing some algebra one can show that:
DOL = sales total VC EBIT

You should be able to use this formula to reconfirm the DOL numbers calculated for the example.

Degree of Combined Leverage Recall that: - DOL translates risk in sales into risk in EBIT - DFL translates risk in EBIT into risk in EPS The degree of combined leverage (DCL) looks at how the two combine.
DCL = percentage change in EPS percentage change in sales

Since the DCL is simply the effect of DFL and DOL combined: DCL = (DFL)(DOL) or

MFIN 6663 Greg MacKinnon Sobey School of Business Saint Mary's University

EBIT sales total VC DCL = EBIT I EBIT sales total VC = EBIT I

Note that there are two parts to the DCL, the DFL and the DOL. The implication is that managers can choose DOL and DFL to offset each other or to meet an overall goal for their total risk exposure. For example, if business risk is high naturally, the firm will probably choose lower leverage (lower DFL) to mitigate this. But, if the firm uses a production process with low FC (low DOL) then this may allow for higher DFL.