LEVERAGE

The use of various financial instruments or borrowed

capital, such as margin, to increase the potential return of
an investment.

The amount of debt used to finance a firm's assets. A firm

with significantly more debt than equity is considered to
be highly leveraged.

Leverage is most commonly used in real estate

transactions through the use of mortgages to purchase a
home

Leverage is the relationship between debt financing and

equity financing, also known as the debt-to-equity ratio.

Equity is created by the personal funds of the business

owner(s), and/or by the stockholders of shares in a
corporation. As these funds have no claim on any of the
assets of the business, the assets are available to be used
as collateral for debt financing.

You can think of leverage as shorthand for your business's

ability to get funding. Higher equity creates increased
leverage and vice-versa. If your business is fully
leveraged, it won't be able to borrow money.

Suppose you applied for a small business loan of $3000

and were prepared to make an equity contribution of
$1000. This would be a debt-to-equity ratio of 3:1.

Whether or not this would be an acceptable ratio to the

lender depends on the lender and your business' position.
If, for example, you are just starting out, a lender may
insist on a debt-to-equity ratio of 1:1.

CAPITAL STRUCTURE
1
The firm combines different securities in its assets in an
attempt to maximize its overall market value. Capital structure in
this sense is the firm’s mix of different sources of finance. It refers to
the way a firm finances its assets through some combinations

of equity, debt, or hybrid securities. A firm's capital structure

in this respect is then the composition or structure of its

liabilities but excluding all short term liabilities.
Basically, a firm’s major source of finance is debt and equity. Equity
includes paid up share capital, share premium, reserves and surplus
while debts includes debentures, loan stocks and bonds.
Clearly defined therefore, capital structure refers to the
relative mix of or the proportionate relationship between debt
and equity securities in the long-term financial structure of a
company.
The capital structure decision is a significant managerial and strategic
decision. It influences the shareholders return and risk. Consequently,
the market value of the share may be affected by the capital structure
decision. Thus, whenever funds have to be raised to finance
investments, a capital structure decision is involved.
Hence, the debt-equity mix has implications for the
shareholders’ earnings and risk, which in turn will affect the
cost of capital and the market value of the firm.

OPTIMAL OR TARGET CAPITAL STRUCTURE

The Optimal Capital Structure is the one that minimizes
the firm’s cost of capital and maximizes its value. It is
the mix or combination of debt, preference shares
and equity that will optimize or maximize the
company's share price and minimize its WACC. As a

2
 company raises new capital it will focus on maintaining
this target or optimal capital structure.

For each company, there is an optimal capital

structure, including a percentage of debt and equity, a
balance between the tax benefits of the debt and the
equity. As a company continues to increase its debt over
the amount stated by the optimal capital structure, the
cost to finance the debt becomes higher as the debt is
now riskier to the lender. The risk of bankruptcy increases
with the increased debt burden. Since the cost of debt
becomes higher, the WACC is also affected. With the
addition of debt, the WACC will at first fall as the
benefits are realized, but once the optimal capital
structure is reached and then surpassed, the increased
debt burden will then cause the WACC to increase
significantly.

CAPITAL STRUCTURE, OPTIMALITY AND THE

VALUE OF A FIRM
The Capital Structure decision of a firm and its optimality are usually
examined from the point of its impact on the value of the firm. If capital
structure decision can affect a firm’s value, then the firm would like to
have a capital structure, which maximizes its market value.

The appropriate questions to ask here is;

‘Is there an optimal capital structure? Does capital structure matter? If
it does, what is the relationship between capital structure and the value
of the firm? Can the total market value of a firm be increased or
decreased by changing the mix of debt and equity financing?’

3
The answer to these questions are not farfetched but lies on two
conflicting theories well documented in the literature and established to
explain the relationship between capital structure, optimality and the
value of the firm. These theories include;

• Theories of Capital Structure Relevance and

• Theories of Capital Structure Irrelevance

In establishing this relationship, certain simplifying assumptions
common to these theories were proposed including;
i. Firms can be financed only through debt and equity

ii. Transaction or floatation cost does not exist

iii. Corporate or personal income taxes does not exist
iv. The ratio of debt to equity of a firm can be changed by
issuing debt to purchase equity or issuing equity to pay
off debt.
v. Bankruptcy costs do not exist.

vi. Individuals can borrow as easily and at the same rate of

interest as the firm.
vii. There are no retained earnings. The firm pays out 100%
of its earnings as dividend.
viii. The operating earnings of the firm are not expected to
grow.
ix. The expected value of the probability distributions of
expected future operating earnings for each company are
the same for all investors in the market.

THEORIES OF CAPITAL STRUCTURE RELEVANCE

Among the leading theories documenting the relevance of capital
structure to the firm’s value includes;
• Net Income Approach
• Traditional Approach

4
 • Modigliani and Miller (M&M) Theory with
Taxes

NET INCOME APPROACH

This theory posits that capital structure is relevant and that the
proportionate use of debt in a firm’s capital structure will increase its
value. It suggests that a firm can vary its value by either increasing or
decreasing it through the financial mix, which is the ratio of debt to
equity. The NI approach is based on the premise that the cost
of debt is cheaper than that of equity and that the optimal
use of debt will result in a decline in WACC.

According to this approach, the average cost of capital (KO) declines

as gearing increases. The cost of shareholders funds (ke) and the cost
of debt (kid) are independent. Since kid is usually less than ke as debt
is less risky than equity from the investor’s point of view, an increase
in gearing should lead to a decrease in ko

As the proponent puts it, the cost of debt is cheaper than

that of equity for the following reasons;
i. Lenders require a lower rate of return than ordinary
shareholders. Debt finance presents a lower risk than shares for
the finance providers because they have prior claims on annual
income and liquidation. In addition security is often provided and
covenants imposed.
ii. A profitable business effectively pays less for debt capital
than equity since debt interest can be offset against pre-tax
profits before the calculation of company tax, thus reducing
the company’s tax liabilities.
iii. Issuing and transaction costs associated with raising and
servicing debt are generally less than for ordinary shares.

5
The Net Income approach can be demonstrated graphically as
follows;

Rate
Of
Return
(%)

Ke

Ko

KD

Debt/Equity

As shown, the cost of equity is constant throughout. An increase in

the level of gearing is consistent with a reduction in the cost of
capital. Thus, as a firm introduces more debt into its capital
structure, the overall cost of capital will decline.
Clearly, the amount of debt that a firm uses to finance its assets is
called leverage. A firm that finances its assets by equity and debt is
called a LEVERED/GEARED firm while a firm that finances its assets
entirely with equity is an UNLEVERED firm.
Hence, under the NI approach;

Cost of Debt (Kd) = Interest

Market Value of Debt

Cost of Equity (Ke) = Earnings available to shareholders

Market value of shares outstanding

Value of the firm (V) = Mkt value of Debt + Mkt value of

equity

6
 (V) =D+E

Accordingly, under this approach, the firm’s overall cost of capital or

expected rate of return (WACC) is expressed as;
Cost of capital = Net Operating Income
Value of firm

Ko = NOI
V

On the whole, under this approach, the firm will achieve its maximum
value and minimum WACC (Optimality) when it is 100% Debt
financed.

TRADITIONAL APPROACH
The traditional approach observed that capital structure is relevant
and argued that there is an optimal capital structure and that the
judicious use of debt finance will lead to a reduction in the cost of
capital until an optimum level is reached.
Gearing beyond the optimal level will lead to an increase in
the cost of capital. The argument is that as companies introduces
debt into its capital structure; the WACC will fall due to the theoretical
lower cost of debt compared with equity finance.
As the level of debt increases, the return required by
ordinary shareholders will start to rise due to the following
reasons;

7
 • The equity provider starts to get worried over the
adequacy of the operating profit to meet the huge debt
interest and still pay dividend.
• Equity providers are equally worried over the possibility
that debenture holders can interfere with the
management of the company.

• The possibility of the company been forced into

liquidation in the event of failure to meet loan interest
payment.
As the returns required by equity holders increases, WACC
will still continue to fall until it reaches a point where
providers of debt will equally demand for higher returns
because;
• A higher level of operating income will be required to meet the
ever increasing debenture interest;
• There may be no adequate physical asset to secure additional
loan or debenture.

Graphically, this can be expressed as follows;

Rate
Of
Return
Ke

8
 Ko

Kd

D/E
Optimum = minimum Ko.

WACC decreases up to a certain level of debt and reaching the

minimum level, starts increasing with financial leverage. Optimal
capital structure is reached where Ko is minimum at which point the
value of the firm is maximised.
Clearly, cost of capital will decrease initially with the use of debt. But
as leverage increases further shareholders start expecting higher risk
premium in the form of increasing cost of equity until a point is
reached at which the advantage of lower cost of debt is more than
offset by more expensive equity.
On the whole, under this approach, capital structure is only relevant
up to the optimal level. This is the point where the cost of debt and
WACC is at its minimum.

M & M HYPOTHESIS WITH TAXES

In their 1963 article, MM showed that capital structure is relevant and
that the value of the firm will increase with debt due to the
deductibility of interest charges for tax computation since leverage
lowers tax payment. Hence, the value of the levered firm will be
higher than that of the unlevered firm.
The interest tax shield/tax advantage is the tax savings that occur on
account of payment of interest to debt holders. The interest tax
shield is a cash inflow to the firm and therefore, it is valuable.
According to them, this interest tax shield can be computed as
follows;

9
 PV of Interest tax shield = (Corporate tax) x (Interest Rate)
Cost of debt

Graphically, this can be shown as follows;

Clearly, with interest tax shield allowed for levered firms, debt
financing is more advantageous than equity financing. Thus, the
optimum capital structure is reached when the firm employs
almost 100% debt.

FINANCIAL LEVERAGE WITH CORPORATE vs. PERSONAL TAX

Companies pay corporate tax on their earnings. Hence, the earnings
available to investors are reduced by the corporate tax. Further,
investors are required to pay personal taxes on the income earned by
them. Therefore, from the point of view of investors, the effect of
taxes will include both company and personal taxes.
A firm should thus aim at minimizing the effect of total taxes (both
corporate and personal) to investors while deciding about borrowings.

IRRELEVANCE OF CAPITAL STRUCTURE

Two theories established the irrelevance of capital structure. These
are the following;

10
 • Net Operating Income Approach

• Modigliani and Miller (M&M) without taxes

NET OPERATING INCOME (NOI) APPROACH

According to this approach popularized by David Durand, the
overall value of the firm and the cost of capital have no relationship
with and are independent of the capital structure and therefore
capital structure is totally irrelevant.

According to the proponent, an increase in debt increases the financial

risk of the shareholders, as they are responsible for the
repayment of the debt. Further increases in leverage will
result in shareholders demanding a higher rate of return on
their investment, hence increasing the cost of equity to a point
that the advantage of cheap debt will be completely wiped out by
the increase in the cost of equity. However, the overall cost of
capital is unaffected and thus remains constant irrespective of the
change in the ratio of debts to equity capital.

Accordingly, the approach decomposed the cost of capital

into two cost elements namely;
(i) The low explicit cost, represented by interest charges on
Debentures/debt and the
(ii) High implicit cost which results from the increase in cost of
equity caused by an increase in the degree of leverage

As a result, the advantage gained in terms of lower cost of

debt (explicit cost) will be neutralized by the disadvantage
in term of high cost of equity (implicit cost). Therefore the cost
of debt and equity will be the same in all capital structures.

11
With this approach, to obtain the total market value of the firm, the
Net Operating income (NOI) of the firm is capitalized at an
overall rate of return. The market value of debt is then
deducted from the total market value of the firm to obtain the
market value of shares.

Thus, under this approach;

Value of the Levered firm = Value of Unlevered firm

Value of the firm (VL) = NOI

Opportunity cost of capital

Ko = NOI
VL

Ke = NOI – Debt. Interest

MVe

This approach is based on the assumption that the overall company’s

cost of capital and cost of debt are constant for all degrees of
leverage and the cost of equity increases linearly with that of
leverage, so that the advantage of cheap debt is completely offset by
increasing equity.

Graphically, this can be shown as follow;

KE

Rate
Of
Return

12
 KO

KD

Debt/Equity

Overall, under the NOI approach, an optimal capital

structure of a firm does not exist. All capital structures
according to the theory are optimal. The increase in ke is exactly
sufficient to offset the effect of the increased importance of kd so ko
is constant.

MM HYPOTHESIS WITHOUT TAXES

Franco Modigliani and Merton Miller in their original 1958 article
observed that in perfect capital markets without taxes, bankruptcy
and transaction costs, a firm’s market value and the cost of capital
remains invariant to the capital structure changes. The value of
the firm depends on the earnings and risk of its assets
(Business risk) rather than the way in which assets have
been financed.
MM began their proposition by making the following assumptions;
1) All physical assets are owned by the firm
2) Capital markets are frictionless. There are no corporate or
personal Income taxes, securities can be purchased or sold
costlessly and instantaneously.
3) Firms can issue only 2 types of securities, risky equity and
risk free debt.
4) Investors have homogenous expectations about future
stream of profits.

13
 5) All investors have complete knowledge of what
future returns will be.
6) All firms within an industry have the same risk
regardless of capital structure
7) No transactions, agency and bankruptcy costs.
8) Individuals can borrow or lend as easily and at the
same rate of interest as the firm.
9) All earnings are paid out as dividends. Thus,
earnings are constant and there is no growth.
10) The average cost of capital is constant

Given these assumptions, the MM hypothesis can best be

explained in terms of their 2 propositions as follows;
• Proposition I
• Proposition II

PROPOSITION I

Consider two firms which are identical (In the same business risk
class, having the same beta and WACC) but different only in their
capital structures. The first firm is unlevered while the other is

14
levered. M&M argued that the two firms must have

identical total values. If they did not, individual

investors would engage in arbitrage and create
homemade leverage and the market forces that would
drive the two values to be equal.

To demonstrate this, suppose an investor is considering buying

one of the two firms Unlevered or Levered. Instead of purchasing
the shares of the levered firm, he could purchase the shares of
unlevered firm and borrow the same amount of money B
that the levered firm does. The eventual returns to either of
these investments would be the same. Therefore the price of the
levered firm must be the same as the price of the unlevered
firm minus the money borrowed, which is the value of the
levered firm’s debt.

Essentially, M&M approach is a Net operating Income

approach
because the value of the firm is the capitalized value of NOI. That is;

V = NOI
Ko

Since no taxes have been assumed, the operating income (EBIT) is

equivalent to the net income which is all paid out as dividends.
Thus, the value of the firm is equal to;

V = EBIT
Ka

Since the value of the firm is equal to the sum of the value of the
debt and equity;

15
 V =D +E.......... .......... .......... ........ i
then
k 0V =k o ( D +E )......... .......... ........ ii
and
E D
ko =k e ( ) +k d ( )........ iii
D +E D +E

Substituting equation (iii) into (ii), and solving for Ke;

D
ke = ko + ( k o − k d )
E

Thus, ke must go up as debt is added to the capital structure.

%
Ke

Ko

Kd

Debt/Equity

Clearly, the basis of MM Proposition I argument is an

arbitrage process and homemade leverage creation.

ARBITRAGE
16
Arbitrage is the riskless, instantaneous process of buying an asset in
one market at a low price, and then reselling it in another market
where the identical asset is selling at a higher price.
Under the arbitrage process, shareholders can switch
between two firms that are identical in all respects except
their degree of leverage. This means that if one of the firms is
considered highly levered, the investors would sell their shares and
buy those of the unlevered firm. This switching process will
continue until the value of both firms is the same.

Two (2) types of arbitrage can be distinguished, including;

• Real Arbitrage and
• Reversed Arbitrage.

REAL ARBITRAGE
Real arbitrage involves the switching by an investor from a levered
firm to an unlevered firm to take advantage of lower risk, increase
in income and sustained income.
For instance, when the value of levered firm is
higher than that of an unlevered firm;
i. An Investor will sell his investment held in that firm

ii. He will borrow propionate to his share of the debt of

the levered firm (at same interest rate)

iii. He will purchase securities of the un-levered firm

equal to his percentage equity holding in the

levered firm
iv. In this switching process, he will earn from the un-

levered firm the same as compare to levered firm

with reduced investment outlay or higher income
as compare to levered firm with full investment
outlay.
17
REVERSE ARBITRAGE
Reversed arbitrage is the process of switching from an unlevered
firm to a levered firm to take advantage of increase in earnings and
guaranteed constant income.
For instance, when the value of un-levered firm is
higher;
i. An investor will sell his investment held in that firm

ii. He will buy securities of the levered firm equal to his

percentage holding in un-levered firm (both equity

shares and debt)
iii. In this process he will gain same income as compare

to levered firm with reduced outlay or higher

income as compare to levered firm with full
investment outlay.
On the basis of the arbitrage process, M&M concluded that
the capital structure decision of a firm does not matter and
is therefore IRRELEVANT. Whatever the financing mix adopted,
the market value of the firm remains the same and it does not help
in creating any wealth for shareholders.

HOMEMADE LEVERAGE
Homemade or personal leverage is the idea that as long as
individuals borrow (or lend) at the same rate as the firm, they
can duplicate the effects of corporate leverage on their own. Thus, if
levered firms are priced too high, rational investors will simply
borrow on personal accounts to buy shares in unlevered firms.

It is a technique individual investors can use to synthetically adjust

the leverage of a firm. Basically, in order to replicate the effects of
leverage in the firm, the individual investor borrows money at the

18
same borrowing rate as the company and adds leverage to his
portfolio.

However, in practice, substituting homemade leverage for corporate

leverage in an individual investor’s portfolio will not reflect
corporate leverage exactly.

PROPOSITION 11
According to M&M, the cost of equity Ke will increase enough to
offset the advantage of cheaper cost of debt so that the opportunity
cost of capital (Ko) does not change.

M&M Proposition II argued that the value of the firm depends on

three factors including;

i. Required rate of return on the firm's assets (Ke)

ii. Cost of debt of the firm (Kd)
iii. Debt/Equity ratio of the firm (D/E)

The excessive use of debt increases the risk of default. Hence, in

practice, the cost of debt will increase with high level of financial
leverage. MM argued that when Kd increases, Ke will increase at a
decreasing rate and may even turn down eventually.

This proposition can be demonstrated graphically as follows;

19
A careful perusal of the graph shows that Ke is upward sloping with
a slope of (Ko – Kd). The reason for this behaviour of Ke is
because as a company borrows more debt and increases its
Debt/Equity ratio, the risk of bankruptcy becomes higher. Since
adding more debt is risky, the shareholders demand a higher rate of
return (Ke) from the firm's business operations.

As leverage (D/E) increases further, Ke continues to increase

but the WACC remains the same even if the company borrows
more debt and increases its Debt/Equity ratio. Ko therefore does not
have any relationship with the D/E ratio. This is the basic identity
of M&M Proposition I and II, that the capital structure of the
firm does not affect its total value.

The conclusion germane from M&M analysis is that capital structure

is irrelevant. Therefore, there is no optimal capital structure for the
firm.

CRITICISMS OF MM IRRELEVANCE HYPOTHESIS

The arbitrage process is the behavioural foundation of MM’s

hypothesis. The arbitrage process may fail to bring equilibrium in
the capital market for the following reasons;
i. Lending and borrowing rate discrepancy.

ii. Non- substitubility of personal and corporate leverage.

iii. Transaction costs exist.

iv. Institutional restrictions.

v. Information asymmetry

20
 vi. Existence of Corporation tax.

Clearly, it is incorrect to assume that Personal leverage is a perfect

substitute for corporate leverage. The existence of limited liability of
firms in contrast with unlimited liability of individuals clearly places
individuals and firms on a different footing in the capital market. In
a levered firm, all investors stand to lose to the extent of the
amount of the purchase price of their shares. But, if an investor
creates personal leverage, then in the event of the firm’s
insolvency, he would lose not only his principal in the shares of the
unlevered firm, but will also be liable to return the amount of his
personal loan.

MM PROVIDED THE FOLLOWING FORMULA

WITH TAXES:

i. Ko = KeVe + KoVo (1 –t)

(Ve +Vd) (Ve + Vd)

ii. KEG = Keu + (Keu - Kd)(Vd) (1 - t)

(Veg)

Where: Keg = Cost of equity of geared firm

Veg = Value of equity of geared firm
Keu = Cost of equity of ungeared firm

iii. Kog = kou(1- VDt )

Vg

iv. Vg = Vu + VDt

WITHOUT TAXES:

i. Ko = KeVe + KdVd
(Ve + Vd) (Ve+Vd)

ii. Keg = Keu + (Keu – Kd)(Vd)

Ve

21
 iii. Kog = Kou

iv. Vg = Vu

OTHER THEORIES OF CAPITAL STRUCTURE

The following theories discussed below are also associated with the
capital structure of the firm and its optimality.

PECKING ORDER THEORY

The Pecking Order Theory popularized by Stewart Myers posits
that internal and external funds are used hierarchically. According

to him, businesses adhere to a hierarchy of financing

sources preferring to finance new investment, first internally with

retained earnings, then with debt, and finally with an issue of new
equity.
It maintained that companies prioritize their sources of
financing (from internal financing to equity) according to
the law of least effort, or of least resistance, preferring to
raise equity as a financing means “of last resort”.
Clearly, according to the proponent, equity is a less
preferred means to raise capital.

Trade-Off Theory of Capital Structure

The Trade-Off theory of capital structure was propounded
and popularised by Kraus and Litzenberger. According
to them, optimal capital structure is obtained where the
net tax advantage or benefit of debt financing balances
or equilibrates leverage related costs such as
bankruptcy and agency costs.

22
It therefore refers to the idea that a company chooses how
much debt finance and how much equity finance to use by
balancing the costs and be nefits.
Clearly, the theory argued that firms usually are financed
partly with debt and partly with equity. It states that there
is an advantage to financing with debt, the tax
benefits of debt and there is a cost of financing with
debt, the costs of financial distress including bankruptcy
and non-bankruptcy costs (e.g. staff leaving, suppliers
demanding disadvantageous payment terms,
bondholder/stockholder infighting/agency problem, etc).
The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost
increases. Thus a firm that is optimizing its overall value
must focus on this trade-off when choosing how much
debt and equity to use for financing.

Information Asymmetry Theory

The information asymmetry theory of capital structure assumes that
firm managers or insiders possess private information about the
characteristics of the firm’s return stream or investment
opportunities, which is not known to common investors.

REASONS FOR PREFERENCE FOR BORROWING

A number of companies in practice prefer to borrow for the following

reasons including;

i. Tax deductibility of interest (tax advantage)

ii. Higher returns to shareholders due to gearing

iii. Complicated procedure for raising equity capital

23
 iv. No dilution of ownership and control

v. Equity results in permanent commitment than debt

OFFSETTING DEMERIT OF DEBT

Several offsetting disadvantages of debt exist in practice. These can
be grouped into the following;

• Personal Taxes (investors pay tax on the interest

gained)

• Financial distress

• Agency problems (conflicts bw DH/SH, SH/MGRS)

PERSONAL TAXES
Personal taxes on interest income reduce the attractiveness of debt.
From the firm’s point of view, there is strong incentive to
borrow, as they will be able to reduce corporate taxes.
However, the advantage of corporate borrowing is reduced by
personal tax loss as investors are required to pay tax on interest.
Thus, the tax saved by the firm is collected in the hands of the
investors.

FINANCIAL DISTRESS
The question to ask here is;
Why do firms tend to avoid very high gearing levels despite
its obvious advantages? One reason is financial distress risk.
Financial distress arises when a firm is not able to meet its
obligations to debt holders. The firm’s continuous failure to make
payments to debt holders can ultimately lead to the insolvency of
the firm.

AGENCY PROBLEMS
Agency costs arise because of the conflict between managers
and shareholders interests, on the one hand, and shareholders

24
and debt holders interests on the other hand. These conflicts give
rise to agency problems, which involves agency costs. The conflict
between shareholders and debt holders arise because of the possibility of
shareholders transferring wealth of debt holders in their favour. Similarly,
the conflict between shareholders and managers arise because
managers may transfer shareholders wealth to their advantage
by increasing their compensation, allowances/ remunerations.
Thus, investors require monitoring and restrictive covenants to
protect their interest.

FACTORS TO CONSIDER IN DETERMINING CAPITAL

STRUCTURE
The determination of capital structure in practice involves additional
considerations. Important amongst these are:
i. Assets
ii. Issue or floatation
iii. Loan covenants
iv. Early repayment
v. Control dilution
vi. Marketability and timing
vii. Capital market conditions
viii. Capacity of raising funds
ix. Tax benefit of Debt
x. Flexibility
xi. Industry Leverage Ratios
(LEVERAGE=DEBT+EQUITY), Fin Leverage reduces
PAT, after paying tax, profit is reduced
xii. Agency Costs

25
 xiii. Industry Life Cycle
xiv. Degree of Competition
xv. Company Characteristics
xvi. Requirements of Investors
xvii. Timing of Public Issue
xviii. Legal Requirements

LEVERAGE/GEARING
Leverage can be decomposed into two (2) categories as follows;

• Financial Leverage

• Operating Leverage

FINANCIAL LEVERAGE
The use of fixed charges sources of funds such as debt and
preference capital along with the owner’s equity in the capital
structure is described as financial leverage or gearing or
trading on equity. The main reason for using financial leverage is
to increase the shareholders returns.
The use of the term trading on equity is derived from the
fact that it is the owners’ equity that is used as the basis to
raise debt; i.e. the equity that is traded upon. The supplier of
the debt has limited participation in the company’s profit and
therefore, he will insist on the protection in earnings and protection
in values represented by owner’s equity.
Financial leverage affects PAT or EPS.
Financial leverage is avoidable, if debt is not introduced into the
firm’s capital structure.

By using a combination of assets, debt, equity, and

interest payments, leverage ratio's are used to
understand a company's ability to meet it long term
financial obligations. The three most widely used leverage
ratio's are the debt ratio, debt to equity ratio, and interest
coverage ratio.

26
The debt ratio gives an indication of a companies total
liabilities in relation to their total assets. The higher the
ratio, the more leverage the company is using and the
more risk it is assuming. Both total assets and
liabilities can be found on the balance sheet. There is a
nuance to be aware of with this formula. Mentioned
above, these leverage ratios are meant to measure long
term ability to meet financial obligations. Well, when we
take a look at our Total liabilities number in more detail,
items such as accounts payable are included. This is a
short term liability which is essential for the proper
functioning of the business and not a liability in the sense
that we are discussing it here.

The debt to equity ratio is the most popular leverage

ratio and it provides detail around the amount of leverage
(liabilities assumed) that a company has in relation to the
monies provided by shareholders. As you can see through
the formula below, the lower the number, the less
leverage that a company is using. Again, like the debt
ratio, we must understand the drawbacks of this formula.
Total liabilities include operational liabilities that are
required to run the business. These are not long term in
nature and can distort the debt to equity ratio. Some will
exclude accounts payable from the liabilities and/or
intangible assets from the shareholder equity component.

The interest coverage ratio tells us how easily a

company is able to pay interest expenses associated to

27
the debt they currently have. The ratio is designed to
understand the amount of interest due as a function of a
companies earnings before interest and taxes (EBIT).
Some will actually replace EBIT with EBITDA. It is different
for each sector, but an interest coverage ratio below 2
may pose a threat to the ability of a company to fulfill its
interest obligations. The interest coverage ratio is very
closely monitored because it is viewed as the last line of
defense in a sense. A company can get by even when it is
in a serious financial bind if it can pay its interest
obligations.

What Does Earnings Per Share

The portion of a company's profit allocated to each

outstanding share of common stock. Earnings per
share serves as an indicator of a company's profitability.

Calculated as:

When calculating, it is more accurate to use a weighted

average number of shares outstanding over the reporting
term, because the number of shares outstanding can
change over time. However, data sources sometimes
simplify the calculation by using the number of shares
outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares

of convertibles or warrants outstanding in the outstanding
shares number.

28
WHAT IS RETURN ON EQUITY (ROE)

The term Return on Equity, or ROE, measures the

amount of profit that a company generates through the
use of shareholders' equity. ROE is one of the most
important profitability ratio'smeasuring management's
ability to perform in areas of profitability, asset
management, and financial leverage. It is calculated by
dividing net income by average common shareholders
equity. The reason we use an average here is due to the
fact that common outstanding shares can fluctuate in size
throughout the year. Companies may bring additional
shares to the market or actually buy them back depending
on their cash needs and expectations for .

It is generally accepted that a company with a higher ROE

is a better investment than one with a lower ROE since it
has a stronger ability to generate cash flowsinternally;
however, this is not completely accurate. Some firms
which have lower asset requirements may have sky high
ROE but the risk of them continuing to maintain that ROE
is not very high as the market for their offering will invite
many competitors. Conversely, there are many industries
that rely heavily on large capex spending to get their
business off the ground; transportation and oil companies
come to mind. These firms will have less competition due
to the high start up costs. The moral of the story here
is to understand the industry that you are investing in and
compare apples to apples.

RETURN ON EQUITY CALCULATION

In its simplest form, the formula used to calculate ROE is

very simple; however, let's take a look at the three
components of ROE as we discussed above. Keeping track
of ROE by measuring each of these three components
individually allows companies to easily identify changes
which are affecting their ROE.

29
When we simplify this formula, we arrive at:

Net income can be found on the income statement while

average common shareholders equity can be found on
the balance sheetby averaging the current fiscal years
shareholders equity with the prior years

Interest Tax Shield

A reduction in tax liability coming from the ability
to deduct interest payments from one's taxable income.
For example, a mortgage provides an interest tax shield
for a property buyer because interest on mortgages is
generally deductible. An interest tax shield may
encourage a company to finance a project through debt
because dividends paid on stock issues are never
deductible.

OPERATING LEVERAGE
Operating leverage is the responsiveness of the firm’s EBIT to
changes in sales revenue. It arises from the firm’s use of fixed
operating costs. When the fixed operating costs are present in the

30
company’s capital structure, changes in sales are magnified into
greater changes in EBIT. Leverage associated with fixed operating
costs.
Operating leverage affects a firm’s operating profit.

COMBINING FINANCIAL AND OPERATING LEVERAGES

Firms use operating and financial leverage in various degrees. The
combined use of operating and financial leverage can be measured
by computing the degree of combined leverage. These combined
effects of two leverages can be quite significant for the earnings
available to ordinary shareholders.
DEGREE OF OPERATING LEVERAGE
Degree of operating leverage (DOL) is defined as the percentage
change in EBIT relative to a given percentage change in sales. Thus,

DOL = % change in EBIT

% change in sales

The following equation can also be used to compute the degree of

operating leverage (DOL) including;

• DOL = Contribution
EBIT

• DOL = Fixed Cost + 1

EBIT

• DOL = Q( S-V )
Q(S-V) -F

• DOL = VC
EBT

DEGREE OF FINANCIAL LEVERAGE (DFL)

31
Financial leverage affects the EPS. When the economic conditions
are good and the firm’s EBIT is increasing, its EPS increases faster
with more debt in the capital structure. The degree of financial
leverage (DFL) is defined as the % change in EPS due to a
given % change in EBIT. That is;

DFL = % change in EPS

% change in EBIT

DFL can also be expressed in any following ways;

• DFL = EBIT
PBT

• DFL = Q(S - V) – F
Q(S - V) – F- Interest

EFFECT OF COMBINED OPERATING AND FINANCIAL

LEVERAGE
Operating and Financial Leverage together can cause wide
fluctuation in EPS for a given change in sales. If a company employs
a high level of operating and financial leverage, even a small
change in the level of sales will have a dramatic effect on EPS.
The degrees of operating and financial leverages can be combined
to observe the effect of total leverage on EPS associated with a
given change in sales.
This can be expressed as;

DCL = DOL +DFL

DCL = Contribution + EBIT = Contribution

EBIT PBT PBT

DCL = Q(S-V) X Q(S-V) –F = Q(S-V)

Q(S-V)-F Q(S-V)-F-Int Q(S-V)-F-Int

32
 FINANCIAL LEVERAGE AND SHAREHOLDER’S RISK
It has been documented that financial leverage magnifies
shareholders earnings. Also, it is established that the
variability of EBIT causes EPS to fluctuate within wider
ranges with debt in the capital structure. That is, with
more debt, EPS rises and falls faster than the rise and fall in
EBIT. Thus, Financial Leverage not only magnifies EPS but also
increases its variability.
The variability of EBIT and EPS distinguishes between 2
types of risk i ncluding:-
i. Operating/Business risk
ii. Financial risk

OPERATING/BUSINESS RISK
It is the variability of EBIT associated with a company’s normal
operations. The environment in which a firm operates
determines the variability of EBIT. So long as the environment
is given to the firm, operating risk is an UNAVOIDABLE risk.
Clearly, it arises due to uncertainty of cash flows of the firm’s
investments.
FINANCIAL RISK
Arises on account of the use of debt for financing investments.
A totally equity financed firm will have on financial risks if the
firm decides not to use any debt in its capital structure.

MEASURES OF LEVERAGE/GEARING
The appropriate question to ask here is; ‘How is
Gearing/Leverage measured?’ Clearly, several measures of
leverage exist in the literature including;

33
 i. Income measure
ii. Market value measure
iii. Book value measure

INCOME MEASURE
This measure indicates the capacity of the firm to meet fixed
financial charges. Under here, the level of gearing is measured
by the ratio of fixed interest payment to the company’s total
profit. That is;
Gearing = Fixed Interest Payable
Total profit after interest before Tax.

BOOK VALUE MEASURE

Book values are historical figures and when used, may not
reflect current prices. The book value of ordinary shares is the
sum of share capital, Reserves/Retained Earnings and share
premium
Gearing using Book values can be measured as follows:-
Gearing = Book value of fixed interest security
Total Book value of capital (D + E)

MARKET VALUE MEASURE

Market values reflect the current attitude of investors and thus
it is theoretically more appropriate. But it is difficult to get
reliable information on market values in practice. The market
values of securities fluctuate frequently. Market value measure
is expressed as;
Gearing = Market value of fixed interest security
Total market value of capital (D + E)

34
FACTORS TO CONSIDER IN DECIDING WHETHER TO USE
EQUITY OR DEBT FINANCE.
In deciding whether to go for equity or debt financing, the
following considerations are important;
a) Dilution of Ownership: If new shares are issued to
new shareholders, it will lead to dilution of control.
Thus if a firm is conscious of retaining control, it can
opt for debt finance.
b) Stability of Earnings: If the company’s earnings are
highly variable, debt finance will increase the
variability and the company’s vulnerability.
c) Security: Issue of debt and the use of debt finance
may require security to be provided by the company.
d) Tax Savings: Interest paid on debt is a tax allowable
expense, giving rise to savings. A firm desirous of this
savings can opt for debt finance.
e) Financial Risk: Borrowing will introduce financial risk
to the company.

TREATMENT OF PREFERENCE SHARES IN GEARING

Preference shares are difficult to classify. It is often considered
to be a hybrid security since it has many features of both
ordinary shares and debentures.
It is similar to ordinary shares in that;
i. The non payment of dividend does not force the company
into liquidation
ii. Dividends are not deductible for tax purposes and
iii. It has no fixed maturity date.
On the other hand, it is similar to debentures because;
35
 • Dividend rate is fixed
• Preference shareholders do not share in the residual
earnings
• Preference shareholders have claims on income and
assets prior to ordinary shareholders.
• They usually do not have voting rights.
Thus, there are two (2) ways to the treatment of this
source of finance. Preference shareholders are regarded as
members of the company during liquidation. Therefore, they
receive no payment until all the creditors have been settled. In
this manner, they are treated just like equity shareholders.
But this type of shareholders equally carries the right to a fixed
dividend and do not share in the residual dividend. In this case,
it is sappropriate to classify preference shares as a form of
borrowing.

Operating leverage is the name given to the impact on

operating income of a change in the level of output.
Financial leverage is the name given to the impact on
returns of a change in the extent to which the firm’s
assets are financed with borrowed money. Despite the
fact that both operating leverage and financial
leverage are concepts that have been discussed and
analyzed for decades, there is substantial disparity in
how they are defined and measured by academics and
practitioners.

In their 1969 college textbook, Weston and Brigham told

some of today’s businessmen and women that, "High fixed
costs and low variable costs provide the greater
percentage change in profits both upward and downward."
[Weston, 86]

36
Today, Brigham says that, "If a high percentage of a firm’s
costs are fixed, and hence do not decline when demand
decreases, this increases he company’s business risk. This
factor is called operating leverage." [Brigham, 425] "If a
high percentage of a firm’s total costs are fixed, the firm is
said to have a high degree of operating leverage ."
{Brigham, 426] "The degree of operating leverage (DOL)
is defined as the percentage change in operating income
(or EBIT) that results from a given percentage change in
sales....In effect, the DOL is an index number which
measures the effect of a change in sales [number of units]
on operating income, or EBIT." [Brigham, 440]

Grunewald and Nemmers told them that, "When fixed

costs are very large and variable costs consume only a
small percentage of each dollar of revenue, even a slight
change in revenue will have a large effect on reported
profits." [Grunewald, 76]

Cherry said that, "Operating leverage, then, refers to the

magnified effect on operating earnings (EBIT) of any given
change in sales...And the more important, proportionally,
are fixed costs in the total cost structure, the more
marked is the effect on EBIT." [Cherry, 254]

Van Horne said that, "one of the most dramatic examples

of operating leverage is in the airline industry, where a
large portion of total costs are fixed." [Van Horne, 680]

Archer and D’Ambrosio in their 1972 textbook said that,

"The higher the proportion of fixed costs to total costs the
higher the operating leverage of the firm..." [Archer, 421]

Schultz and Shultz, said that, "Since a fixed expense is

being compared to an amount which is a function of a
fluctuating base (sales), profit-and-loss results will not
bear a proportionate relationship to that base. These
results in fact will be subject to magnification, the degree
of which depends on the relative size of fixed costs vis-a-
vis the potential range of sales volume. This entire subject
is referred to as operating leverage." [Schultz, 86]

where:

37
 • q = quantity
• p = price per unit
• v = variable cost per unit

• f = total fixed costs

Block and Hirt say that operating leverage measures the

effect of fixed costs on the firm, and that the degree of
operating leverage (DOL) equals:

DOL = q(p - v) divided by q(p - v)

-f

that is:

Degree of operating leverage =

Sales revenue less total variable cost divided by

sales revenue less total cost

Buccino and McKinley define operating leverage as the

impact of a change in revenue on profit or cash flow. It
arises, they say, whenever a firm can increase its
revenues without a proportionate increase in operating
expenses. Cash allocated to increasing revenue, such as
marketing and business development expenditures, are
quickly. "consumed by high fixed expenses." (This is
certainly a different definition!)

In his 1997 article, Rushmore says that positive operating

leverage occurs at the point at which revenue exceeds the
total amount of fixed costs.

There seems to be more uniformity in the definition of

financial leverage. "Financial leverage," say Block and
Hirt, reflects the amount of debt used in the capital
structure of the firm. Because debt carries a fixed
obligation of interest payments, we have the opportunity
to greatly magnify our results at various levels of
operations. [Block, 116]

38
According to Weston and Brigham back in 1969, the
degree of financial leverage is computed as the
percentage change in earnings available to common
stockholders associated with a given percentage change
in earnings before interest and taxes.

According to Brigham in 1995, "The degree of financial

leverage (DFL) is defined as the percentage change in
earnings per share [EPS] that results from a given
percentage change in earnings before interest and taxes
(EBIT), and it is calculated as follows:"

DFL = Percentage change in EPS divided by

Percentage change in EBIT

This calculation produces an index number which if, for

example, it is 1.43, this means that a 100 percent increase
in EBIT would result in a 143 percent increase in earnings
per share. (It makes no difference mathematically if return
is calculated on a per share basis or on total equity, as in
the solution of the equation EPS cancels out.)

Clarity in regard to operating and financial leverage is

important because these concepts are important to
businesses. As Conrad Lortie observes in an article, small
and medium-sized business often have difficulty using the
highly sophisticated quantitative methods large
companies use. Fortunately, he observes, the simple
break-even graph is simple and easy to interpret; yet it
can provide a significant amount of information. The
algebra necessary to compute operating and financial
leverage, too, is not very complex. Unfortunately, it comes
in a several guises; not all equally easy to understand or
equally useful.

Operating
Leverage

To make it readily apparent something that is wrong with

the typical description of operating leverage, a very

39
simple example is used in Tables 1 and 2. Assumed is that
Widget Works, Inc. has fixed costs of $5,000 and variable
costs per unit of $1.00. Bridget Brothers, on the other
hand, has fixed costs of $2,000 and variable costs per unit
of $1.60. Both firms’ selling price is $2.00 per unit. Shown
in Tables 1 and 2 (below) are their revenues and costs for
the production of up to 25,000 units of output.

Table 1

Widget Works, Inc.

Total
Number Total
Variabl
EBIT Profit
e
of Units Cost
Cost
5,000 $10,000 $ 5,000 $10,000 $ 0
10,000 20,000 10,000 15,000 5,000
15,000 30,000 15,000 20,000 10,000
20,000 40,000 20,000 25,000 15,000
25,000 50,000 25,000 30,000 20,000

Table 2

Gidget Brothers

Total
Number Total
Variabl
EBIT Profit
e
of Units Cost
Cost
5,000 $10,000 $ 8,000 $10,000 $ 0
10,000 20,000 16,000 18,000 2,000
15,000 30,000 24,000 26,000 4,000
20,000 40,000 32,000 34,000 6,000

40
 25,000 50,000 40,000 42,000 8,000

Someone looking at the data in Tables 1 and 2 who is

familiar with descriptions of operating leverage like those
cited earlier would say that Widget Works, Inc. has the
higher degree of operating leverage because its its fixed
cost is absolutely and relatively larger than Bridget
Brothers’. Yet, computing operating leverage as Brigham
does: the percent change in operating profit (EBIT) divided
by the percent change in the number of units produced,
indicates that both firms experience the same amount of
operating leverage when these firms increase their output
from 5,000 to 10,000 units. (See below.)

DOL = [c(p -v)] / [q(p - v) -f]

divided by c/q

where:

DOL = operating q
p = price per unit
leverage = original quantity
c = change in v = variable cost
f = total fixed costs
quantity per unit

The above equation simplifies to:

DOL = [q(p - v)] divided by [q(p - v) -

f]

therefore, when quantity increases from 5,000 to 10,000:

• Widget Works: DOL = $5,000/$5,000 divided by

5,000/10,000 = 2
• Bridget Brothers: DOL = $5,000/$5,000 divided by
5,000/10,000 = 2

Block and Hirt’s method produces the same results when

operating leverage is computed at the 10,000 unit level of
output.

41
 • Widget Works: DOL = 10,000($2 - $1) divided by
5,000/10,000 = 2
• Bridget Brothers: DOL = 10,000($2.00 - $1.60)
divided by 10,000($2.00 - $1.60) - $2,000 = 2

An even more extreme case is produced by letting Widget

Works, Inc. have fixed costs of $10,000 and variable costs
per unit of $1.00, while Bridget Brothers has fixed costs of
only $100 and variable cost per unit of $1.99. Observe
that now Widget Works’ fixed costs are 100 times Bridget
Brothers’, and that its variable costs are just barely over
one-half of Bridget Brothers’.

For Widget Works at 20,000 units of output:

DOL = 20,000($2.00 - $1.00) divided by

20,000($2.00 - $1.00) - $10,000 = 2

For Bridget Brothers at 20,000 units of output:

DOL = 20,000($2.00 - $1.99) divided by

20,000($2.00 - $1.99) - $100 = 2

The explanation for the equality of operating leverage in

the two examples above when, if the equation for figuring
the degree of operating leverage did what is supposed to
do: reflect the difference in the relative importance of
fixed cost, is that in both cases break-even takes place at
the same level of output, and each product sells for the
same price. Why this is true is explained in Appendix 1

This is not, however, the only situation in which operating

leverage does to distinguish between firms whose fixed
costs’ relative size differs. For example, assume that
Widget Works, Inc. has a selling price of $3; variable costs
per unit of $1; and fixed costs of $100. Assume that
Bridget Brothers has a selling price of $0.40; variable
costs per unit of $0.20, and fixed costs of $10. At 100
units of output, leverage, respectively, is, where w stands
for Widget Works and B stands for Bridget Brothers:

OLw = [100($3.00 - $1.00)] / [100($3.00 - $1.00) -

$100] = 2

42
 OLb = [100($0.40 - $0.20)] / [100($0.40 - $.20)] -
$10] = 2

How to determine which sets of data produce the

same DOL is shown in Appendix 2.

Fixed costs play no role in determining how rapidly profit

rises after break-even. This is determined by the ratio of
variable cost per unit to price per unit.

It is true, of course, that if a businesses substitutes capital

for labor; thereby raising its fixed costs, it will
simultaneously reduce a variable cost, labor cost, per unit.
Some businesses by their very nature, such as airlines,
must employ a high ratio of capital to labor. If at the
maximum possible level of output fixed costs are a large
percent of total costs, price per unit will have to be high
relative to variable cost per unit in order for the business
to be able to earn a profit. If a price much greater than
variable cost per unit cannot be obtained, the business will
be liquidated.

What Counts: The Bottom Line

Since the "bottom-line" for a business is the rate of return

on equity, it would seem that the most appropriate
method of computing operating leverage is to compute
what EBIT will be at various levels of output.

The change in the rate of return as a result of

increasing the level of output is:

r2 - r1 = (q2 - q1)(p - v) divided

by e

where:

e is the value of equity,

and r2 is the return after output is changed from

q1 to q2 where q1 < q2

43
In evaluating the wisdom of their investment in a
corporation, its owners should use the current market
value of its stock, because this is what they would have
available to invest elsewhere if they liquidated the stock.

Businesses change the level of output in order increase

the rate of return enjoyed by their owners. This can be
done either by selling more units or avoiding producing
units which cannot be sold without a rate-of-return-
reducing reduction in price. Here it is assumed that
changing the level of output will not affect price, which is
certainly often true in the real world for a small business.

Owners’ rate of return before interest and taxes (r)

= EBIT divided by e or:

r = q(p - v) - f divided by e

where: e = equity

r’s value after there is a change in level of output =

q1(p - v) - f (+) or (-) (q2 - q1)(p - v) divided by

e

let i = interest expense ($)

then:

r2 - r1 = [q2(p - v) - f - i - q1(p - v) - f - i] divided by

e

this simplifies to:

(q2 - q1)(p - v) divided by e

The simplified version of equation of the equation reveals

that the change in owners’ rate of return resulting from a
change in the level of output is not affected by interest
expense.

44
 A Suggested New Way to Measure Operating
Leverage

Tables 1 and 2 make clear the fact that the difference in

the bottom-line impact of changing the level of output
between Widget Works, Inc. and Bridget Brothers isn’t the
rate at which profit expands after break-even, as in both
cases it doubles between 10,000 and 20,000 units; rises
by fifty percent between 20,000 and 30,000; etc., instead
it is Widget Works’ higher ratio of profit to total revenue.
Therefore, a simpler, more meaningful way to the
owner(s) of a business to measure operating leverage is to
compute the change in the following ratio resulting from a
given increase or decrease in the level of output from its
current level.

m = pq - (qv + f) divided by
pq

where:

m = profit margin before interest and taxes, that is,

EBIT/sales revenue

The value of this ratio is greater the lower is the ratio of

variable cost per unit to price per unit; so, the greater is
this ratio, the higher is operating leverage.

Financial Leverage

Operating leverage refers to the fact that a lower ratio of

variable cost per unit to price per unit causes profit to vary
more with a change in the level of output than it would if
this ratio was higher. Financial leverage refers to the fact
that a higher ratio of debt to equity causes profitability to
vary more when earnings on assets changes than it would
if this ratio was lower. Obviously, the profits of a business
with a high degree of both kinds of leverage vary more,
everything else remaining the same, than do those of
businesses with less operating and financial leverage.
Greater variability of profits, of course, means risk is
higher. Therefore, in deciding what is the optimum level of

45
leverage, what is an acceptable risk/return tradeoff must
be determined.

The degree of financial leverage (DFL) is sometimes

measured in the following manner:

DFL = [q(p - v) - f - i] / e divided by [q(p -v) - f] / [e

+ d]

where: d is the value of a firm’s liabilities and

equity plus liabilities = assets = e + d

that is:

DFL = rate of return on equity when borrowed

money

is used divided by rate of return on assets

By assuming various levels of debt financing at various

interest rates, equation 13 can be used to judge the
impact at various levels of output of using more or less
debt financing or paying different interest rates for a given
amount of debt financing.

Suggested New Way to Measure Financial Leverage

It is quite simple to compute what the impact on owners’

rate of return will be as a result of borrowing a given
percent of the money used to finance a firm’s assets:

re = (d/e)(ra - rd) +
ra

where:

• d = debt (either as $ or %)
• e = equity (either as $ or %)
• rd = interest rate on debt (%)

• ra = return on assets (%)

46
Example: Assuming 70 percent of a firm’s assets are
financed with debt costing 8 percent and return on assets
is 12 percent, this equation indicates owners will earn
21.33 percent:

2.33 (.12 - .08) + .12 = 2.33(.04) + .12 = .093 + .12

= .213

Owners’ return rises by 9.33 percent as a result of the

financial leverage obtained by 70 percent debt financing
at a cost of 8 percent. If borrowing rose above 70 percent,
this figure would rise, that is, financial leverage would be
greater. If financial leverage is measured, instead, as an
index number, an additional calculation is necessary to
determine what return on equity it produces.

To confirm that this equation is a valid way to measure the

impact on the bottom line of financial leverage, assume
that assets = $100,000. This means that EBIT = $12,000.
Interest cost is $5,600 (.08 x $70,000). So EBT is $6,400
($12,000 - $5,600). $6,400 is a 21.3 percent return on
equity of $30,000.

The return on assets would, of course, vary with the

assumed level of output.

The return on assets and the return on equity =

ra = (qp - qv - f )/a and

re = (d/e)[(qp - qv - f )/a) - rd] + (qp - qv - f
)/a

that is:

The return on equity = (the ratio of debt to equity) times

(the return on assets minus the cost of debt plus the return
on assets)

Interaction Between Operating and Financial

Leverage

47
 The interaction of operating and financial leverage is
illustrated using data in Table 3.

Table 3

The Impact on Financial Leverage of

Increasing the Level of Output

Variabl
Interest Price e Total
Financial Level
of Equity Debt Expens Per Cost Fixed
Leverag
e Output e Unit Per Cost
Unit
$1,00 $1,00
1.33 200 $50 $3 $2 $50
0 0
1.71 400 1,000 1,000 50 3 2 50

In the example shown in Table 3 (above), the interest rate

is 5 percent ($50/$1,000). When the level of output is 200,
the return on assets ($2,000) is 7.5 percent (EBIT = $3 x
200 - $2 x 200 - $50). When the output level is 400, the
return on assets is 17.5 percent (EBIT = $3 x 400 - $2 x
400 - $50).

The return on equity ($1,000) when the level of output is

200 is 10 percent (EBT = $3 x 200 - $2 x 200 - $50 - $50).
When the level of output is 400, it is 30 percent (EBT = $3
x 400 - $2 x 400 -$50 - $50). Therefore, when the level of
output is 200, owners’ rate of return is increased from the
7.5 percent they would have earned if they had invested
$2,000 to the 10 percent they would earn by investing
only $1,000 and borrowing another $1,000 at a cost of 5
percent. That is, their return is increased by 33.3 percent--
1.33 times more. When the level of output is 400, they
experience an even higher degree of favorable financial
leverage, earning 30 percent, rather than 17.5 percent--
1.71 times more. (If the return on assets fell below 5
percent, the rate of return they earn would be less than

48
they would have earned if they had not borrowed any
money.)

The bottom-line impact of financial leverage can be

measured in the following way:

rd - re = [q(p - v) - f - i] / e - [q(p - v) - f] / ( e
+ d)

where:

rd = return with borrowing and re = return without

borrowing

NOTE: The amount of assets being financed is held

constant in order to determine the advantage of using
creditors money, rather than owners' money. Tberefore, if
there is no borrowing, equity (e) will be greater by the
amount of foregone debt (d). The larger amount of equity
is measured above as (e + d).

Which is more useful? Knowing that your rate of return will

increase by 1.33 percent, or that it will rise from 7.5
percent to 10 percent? While, obviously, each can be used
to determine the other, why would the business person
want to go through an intermediate step in order to
determine the bottom-line effect which, most assuredly, is
something he or she will want to know!

Measuring Combined Leverage

The combined impact of operating and financial leverage

can be measured by an index number in the following
manner:

OFL = [q2(p -v) - f - i] / e divided by [q1(p-v) - f] /( e

+ d)

Solving this equation where:

p=$2 v=$1 f = $ 50 i = $ 50
e = $1,000 d = $1,000 q1 = 200 q2 = 400

49
 means: DFL = .30/.075 = 4.0

Adding 200 additional units of output and obtaining half

the firm’s financing from lenders will increase owners’ rate
of return from 7.5 percent to 30 percent (4.0 times 7.5
percent = 30 percent.).

What Does Degree Of Combined Leverage -

DCL Mean?
A leverage ratio that summarizes the combined effect the
degree of operating leverage (DOL), and the degree of
financial leverage has on earnings per share (EPS), given a
particular change in sales. This ratio can be used to help
determine the most optimal level of financial and
operating leverage to use in any firm. For illustration, the
formula is:

Investopedia explains Degree Of Combined

Leverage - DCL
This ratio can be very useful, as it summarizes the effects
of combining both financial and operating leverage, and
what effect this combination, or variations of this
combination, has on the corporation's earnings. Not all
corporations use both operating and financial leverage,
but if they do, then this formula can be used.

It is worth noting that a firm with a relatively high level of

combined leverage is seen as riskier than a firm with less
combined leverage, as the high leverage means more
fixed costs to the firm.

Combined Leverage

Combined leverage, as the name implies shows the

total effect of the operating and financial leverages. In
other words, combined leverage shows the total risks

50
associated with the firm. It is the product of both the
leverages.

Degree of Combined Leverage (DOL) = DOL * DFL

As represented above, the degree of combined

leverage measures the percentage of change in Earnings
per share as a result of a percentage change in Sales. The
combined leverage can work in either direction. It would
be favorable if sales increase and unfavorable in the
reverse scenario. It serves as an important measure in
choosing financial plans as EPS measures the ultimate
returns available to the owners of the company. For
example, if the company invests in more risky assets than
usual, the operating leverage of the company will
increase. If the company does not change its capital
structure, the financial leverage will not change. These
two actions will increase the combined leverage of the
firm, as a result of increase in the operating leverage.

As said, the combined leverage measures the total

risk of the firm. If the firm wants to maintain the risk or not
to increase the risk, it would try to lower the financial
leverage to compensate for the increase in operating
leverage so that the combined leverage remains the
same. Lowering the financial leverage can be done if the
new investments are made in equity rather than debt.
Similarly, in cases where the operating leverage has
decreased due to lower fixed operating costs, the firm can
think of having a more levered financial structure and still
keep the combined leverage constant, thereby increasing
the earnings per share of the equity holders. These are
the advantages of measuring the combined leverage.

Example :

51
 A firm selling price of its product is $100 per unit. The
variable cost per unit is $50 and the fixed operating costs
are $50,000 per year. The fixed interest expenses (non-
operating) are $25,000 and the firm has 10,000 shares
outstanding. Let us evaluate the combined leverage
resulting from sale of 1) 2000 units & 2) 3000 units. Tax
rate = 35%.

A combined leverage (total risk) of 4 indicates that for

every $1 change in sales, there would be a $4 change in
the Earnings per share in either direction.

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Operating leverage has often been misleadingly

described. It’s magnitude is determined by the ratio of
variable cost per unit to price per unit, rather than by the
relative size of fixed costs.

Because business owners evaluate the success of the

operation of their business on the basis rate of the return
earned on equity, measures of operating and financial
leverage that produce percent rates of return would
appear to be more useful to them than those that produce
index numbers.

The following equation can be used to determine the

current rate of return on equity before taxes and the
impact on it of a change in the level of output, amount of
debt financing, cost of debt financing, price, and costs. It
can be used to compute the impact of either operating or
financial leverage or both of them simultaneously. (If no
debt financing is used, the term d/e would, of course, be
omitted from the equation.)

53
 re = (d/e)[(qp - qv - f )/a) - rd] + (qp - qv - f
)/a

That is:

The return on equity = (the ratio of debt to equity) times

(the return on assets minus the cost of debt plus the return
on assets)

A ratio of two versions of this equation produces an index

number that will, by placing in the numerator the equation
involving the higher level of output and/or debt to equity
ratio, measure the degree of operating or financial
leverage, that is, a ratio of the rate of return on equity
after the level of output is increased or more debt is
utilized to the rate of return before these changes are
made.

It is to the business community’s advantage for methods

of financial analysis to be easy to learn and apply.
Adopting this equation appears to be a way to achieve
this.

FINANCIAL LEVERAGE AND THE

SHAREHOLDERS RISK

People using financial leverage invest small amounts of

initial principal to control larger amounts of assets. People
exploit the increased buying power for potential returns
that far exceed what is available on the original principal,
alone. Be advised that risks increase with leverage,
because your principal value is exposed to the volatility of
a larger asset position.

54
Types

Debt financing and derivatives are two business strategies

that people associate with leverage. Highly
leveraged businesses take on more debt than equity, in
order to finance operations. Consumers leverage
mortgages to buy real estate. For example, you may put
down $10,000 to take out one $90,000 mortgage on a
$100,000 home. In one year, the home gains 15 percent in
value to be appraised at $115,000. At that point, you can
sell the property to pay off the loan, and your initial
principal investment has now more than doubled to
$25,000. People leverage derivatives to control assets.
Investors purchase options, futures and forward contracts
to buy positions in stocks, foreign exchange and
commodities at set prices. For $845, investors can buy
one Exxon call option contract for rights to buy 100 shares
of Exxon at $50 per share, through July 2010. Rather than
paying more than $5,000 to buy 100 shares of Exxon,
investors can use options to control the position for $845.

Effects

Financial risks increase with smaller principal payments

that translate into higher amounts of leverage. Derivatives
that grant rights to purchase an asset for a set strike price
will expire worthless--if the market price falls below the
strike price. With the aforementioned Exxon options, you
will lose your entire investment--if Exxon trades for less
than $50 at the end of July. At that point, investors may
purchase Exxon within financial markets at lower prices
than the $50 strike price call options. Alternatively, you
may use margin to borrow against brokerage account
balances to increase your Exxon stake. You may put down
$5,000 of your own cash to buy $6,000 worth of Exxon--
with a $1,000 margin loan. Relative to options, risks are
reduced because of your larger proportions of equity.

Considerations

Debt financing risks shift with the prevailing interest rate

environment. Higher interest rates make it more difficult
55
for you to find profitable assets that provide cash flow
above borrowing costs. The Federal Reserve Board
manages prevailing interest rates through monetary
policy. The Fed targets higher interest rates and borrowing
costs to slow down the economy, which combats inflation.

Warning

People that use debt financing may become upside down

on their investments, when asset values fall. At that point,
your debt principal is higher than its leveraged assets.
Therefore, you cannot immediately sell your investments
to pay off the debt.

Strategy

Balance financial leverage with large cash reserves and

outside assets. Lenders reward financial stability with
offers for lower interest rates. Further, a strong personal
balance sheet provides cash flow to meet expenses and
make timely debt payments if leveraged assets don’t
perform well.

OPERATING RISK

A form of risk that summarizes the risks a company or firm

undertakes when it attempts to operate within a given
field or industry. Operational risk is the risk that is not
inherent in financial, systematic or market-wide risk. It is
the risk remaining after determining financing and
systematic risk, and includes risks resulting
from breakdowns in internal procedures, people and
systems.

56
Operational risk can be summarized as human risk; it is
the risk of business operations failing due to human error.
Operational risk will change from industry to industry, and
is an important consideration to make when looking at
potential investment decisions. Industries with lower
human interaction are likely to have lower operational
risk.

FINANCIAL RISK
Financial risk is an umbrella term for any risk associated
with any form of financing. Typically, in finance, risk is
synonymous withdownside risk and is intimately related to
the shortfall, or the difference between the actual return
and the expected return (when the actual return is less).
Risk related to an investment is often called investment
risk. Risk related to a company's cash flow is
called business risk.
A science has evolved around managing market and
financial risk under the general title of modern portfolio
theory initiated by Dr.Harry Markowitz in 1952 with his
article, Portfolio Selection

The risk that a company will not have adequate cash flow
to meet financial obligations.

Financial risk is the additional risk a shareholder bears

when a company uses debt in addition to equity financing.
Companies that issue more debt instruments would have
higher financial risk than companies financed mostly or
entirely by equity.

EXAMPLE

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

57
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:

Recession Average Boom

EBIT $50,000 $200,000 $350,000
Interest 0 0 0
Taxable 50,000 200,000 350,000
Income

58
Tax (@ 40%) 20,000 80,000 140,000
Net Income $30,000 $120,000 $210,000

Return on 3% 12% 21%

Equity
EPS $0.30 $1.20 $2.10

59
Firm B:

Recession Average Boom

EBIT $50,000 $200,000 $350,000
Interest 50,000 50,000 50,000
Taxable 0 150,000 300,000
Income
Tax (@ 40%) 0 60,000 120,000
Net Income $0 $90,000 $180,000

Return on 0 18% 36%

Equity
EPS $0 $1.80 $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

60
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 β 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,
β asset=β equity

where: β equity is the beta of the stock of the firm (from

CAPM).
If the firm is levered:
β asset<β equity

61
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 Method B
Fixed Costs: $1000/year $2000/year
Variable Costs: $8/unit $6/unit
Price: $10/unit $10/unit
Contribution $2 $4
Margin:

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.

62
More operating leverage means more business risk (and
therefore a higher beta for the firm’s 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.

63
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 firm’s DFL

percentage change in EPS

DFL =
percentage change in EBIT

Example:
Use numbers from last handout.

Use EBIT = $200,000 as a base.

Firm A:
2.10 − 1.20
DFL A ,200000 = 1.20
350000 − 200000
200000
0.75
=
0.75
=1

64
 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
Firm B:
3.60 − 180
.
DFL b,200000 = 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

( EBIT − I)(1 − T)
EPS =
S

$1 change in EBIT gives;

( EBIT + 1 − I)(1 − T) ( EBIT − I )(1 − T)

−
Percentage change in EPS = S S
( 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:

EBIT
DFL =
EBIT − I

65
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 20,000 50,000 100,000

Sales 200,000 500,000 1,000,000

fixed cost 100,000 100,000 100,000
variable costs 60,000 150,000 300,000
EBIT 40,000 250,000 600,000

Firm B:
Unit sales 20,000 50,000 100,000

Sales 200,000 500,000 1,000,000

fixed cost 150,000 150,000 150,000
variable costs 40,000 100,000 200,000
EBIT 10,000 250,000 650,000

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).

66
[The DFL then determines how risk in EBIT translates into
risk in EPS.]

How to measure DOL?

percentage change in EBIT

DOL =
percentage change in sales

67
From the above numbers:

600000 − 250000
DOL = 250000
A, 500000
1000000 − 500000
500000
1.4
=
1
= 1.4

650000 − 250000
DOL B , 500000 = 250000
1000000 − 500000
500000
= 1.6

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:

sales − total VC
DOL =
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.

percentage change in EPS

DCL =
percentage change in sales

68
Since the DCL is simply the effect of DFL and DOL
combined:

DCL = (DFL)(DOL)

or

 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.

RISK RETURN TRADE-OFF

TRADITIONAL wisdom on the risk-return relationship is

that the greater the risk associated with an investment,
the higher should be the compensation -- otherwise
described as the risk premium.

An investment decision should, thus, depend primarily on

the returns realised after taking into account the risk. This
can be assessed using an indicator of the returns
expressed as a unit of risk. The actual number is arrived at
by dividing the returns by the variation in returns as
measured by the standard deviation of the returns.

Business Line analysed the returns per unit of risk on the

Nifty stocks on monthly, quarterly, half-yearly and yearly
basis. On an absolute return basis, 20 stocks posted

69
positive average annual returns above the average bank
deposit rate of 10 per cent. However, after adjusting for
risks, only 12 provided returns over the average bank
deposit rate. The best performers, post-adjustment for
risk, include FMCG and technology players.

An interesting trend that emerged from the returns per

unit of risk analysis was that some of the leading FMCG
companies, such as HLL, Britannia, Nestle and ITC,
performed well, over the last seven years. Historically,
FMCG stocks had lower volatility than some of the fancied
sectors.

This is a positive factor for investors in times of volatility.

A portfolio of FMCG stocks loses value during periods of
volatility at a much lower rate than a portfolio of non-
FMCG stocks. This is a fundamental difference between
investing in technology and FMCG stocks.

Both the technology and FMCG sectors posted fairly good

returns over the seven-year period. However, the risks
associated with the former is higher than that for the
latter. The reason is fairly simple. Because of the
evolutionary nature of the business, the perception of
value of technology businesses and the premium
associated with companies in this sector vary among
market players.

This uncertainty induced by changing perceptions leads to

higher risk, as reflected in the price movements. This is
evident from the fact that HCL Infosystems and Satyam
Computers have monthly return volatility levels of 3.51
per cent and 3.80 per cent respectively.

Compared to this, the FMCG stocks have a lower level of

volatility. The reasons could be that the market
understands the business of these companies better than
it does that of technology firms. Even historically, FMCG
stocks have recorded good returns, making them good
defensive plays. Consequently, these stocks may be
viewed more as defensive stocks, leading to lower
speculation in the market. Hence, prices tend to be more
stable.

70
This is evidenced by the fact that Nestle and Britannia
have risk levels on monthly returns of 1.71 per cent and
1.41 per cent. Further, the risk level of the FMCG giant,
HLL, is around 1.80 per cent, close to the index volatility
level of 2 per cent. Hence, HLL may be a good proxy for
the index per se.

The only major in the FMCG sector to have registered

significant losses is Colgate Palmolive. The company has
been losing market share to HLL over the last few years.
Its poor price performance can be attributed to this. At the
same time, its risk level is close to HLL's.

Safe options

Among all investment avenues, equity is the riskiest.

Theoretically, there is a possibility that at times when the
equity market volatility is high, most stocks are going
through a volatile phase. This may lead to some investors
moving from the high-risk equity class to the lower-risk
bonds and bank deposits. In mid-1998, for instance, when
the equity market was being hammered down, many
investors moved to such safer options treasury bonds.

India does not have a deep debt market. Most investments

in debt securities are likely to be in bank deposits and
fixed deposits of manufacturing companies. For instance,
the fixed deposit programme of Tata Power, an index-
based stock, offers a yearly rate of return of around 11 per
cent.

However, over the last seven years, the company's equity

returns have been lower than 5 per cent. It goes to show
that, in some cases, especially Old Economy stocks,
investors may be better off investing in debt than in
equity.

Taking a more conservative position, an analysis of the

number of stocks that recorded an average annual return
greater than the bank deposit rates indicates that only 20
managed to post positive returns. One has to consider the
fact that the average bank rate may have been
conservative, given the higher interest rates prevailing in

71
the market before 1999. Overall, the indications are that a
long-term investment in the equity market may not pay
off.

Given these market conditions, a 20 per cent average

annual return on equity investments would be an
acceptable benchmark. But based on these criteria, only
13 stocks managed to post higher returns on an
annualised basis. Among the bluechips that did not make
the positive list are ICICI, Larsen and Toubro, Reliance
Industries and Tata group companies.

Significantly, a majority of the bluechip stocks in the

negative territory were from the economically-sensitive
sector. This trend is likely to continue given the general

72
market trends and the current preferences of the
institutional investors

CONCLUSION

Operating leverage has often been misleadingly

described. It’s magnitude is determined by the ratio of
variable cost per unit to price per unit, rather than by the
relative size of fixed costs.

Because business owners evaluate the success of the

operation of their business on the basis rate of the return
earned on equity, measures of operating and financial
leverage that produce percent rates of return would
appear to be more useful to them than those that produce
index numbers.

The following equation can be used to determine the

current rate of return on equity before taxes and the
impact on it of a change in the level of output, amount of
debt financing, cost of debt financing, price, and costs. It
can be used to compute the impact of either operating or
financial leverage or both of them simultaneously. (If no
debt financing is used, the term d/e would, of course, be
omitted from the equation.)

re = (d/e)[(qp - qv - f )/a) - rd] + (qp - qv - f

)/a

That is:

The return on equity = (the ratio of debt to equity) times

(the return on assets minus the cost of debt plus the return
on assets)

A ratio of two versions of this equation produces an index

number that will, by placing in the numerator the equation
involving the higher level of output and/or debt to equity
ratio, measure the degree of operating or financial

73
leverage, that is, a ratio of the rate of return on equity
after the level of output is increased or more debt is
utilized to the rate of return before these changes are
made.

It is to the business community’s advantage for methods

of financial analysis to be easy to learn and apply.
Adopting this equation appears to be a way to achieve
this.

74