Leverage & Capital Structure

Prepared By:PANKAJ PREET SINGH MBA 2-D ROLL NO:-15423

Leverage
A firm is said to be leveraged if it has fixed costs. There are two types of leverage:

Operating leverage fixed costs associated with running the firm. Financial leverage fixed costs associated with financing the firm.

Degree of leverage

Measure of how much leverage the firm uses.

Capital Structure

The mix of long-term financial sources used to finance the firm.

It usually refers to the specific proportions of debt, equity, preferred stock, etc. used to finance the firm.

Only long-term included.

sources

are

Breakeven Analysis

Finding the level of operations necessary to cover all costs.

Can also be used to analyze the level of profitability associated with differing levels of sales. The level of sales necessary to cover all operating costs:
The

Operating breakeven point:

points where EBIT = $0.

A Stylized Approach

The algebra:
PQ-VQ-F=EBIT (P-V)Q-F=EBIT

Solving for Q when EBIT = $0:

Q=F/(P-V) Most companies dont sell only one product/service, and therefore quantity is not as reliable as sales volume.

Practical problem:

Operating Leverage
Operating leverage is the use of fixed operating costs to magnify the effects of changes in sales to the firms operating earnings. Operating leverage is particularly useful if the firm can substitute variable for fixed costs.

Measuring Op. Leverage

Degree of Operating Leverage:

% Change in EBIT DOL % Change in Sales

Financial Leverage

Financial leverage is the use of fixed financial costs to magnify the effects of changes in sales to the firms net earnings.

Sources of financial leverage are primarily debt and preferred stock.

Measuring Fin. Leverage

Degree of Financial Leverage:

% Change in Net Earnings DFL % Change in EBIT

Composite Leverage
Composite leverage is the use of any fixed costs to magnify the effect of changes in sales on the firms net earnings. The two components of total leverage are operating and financial leverage.

Categorizing two components depend on where on the income statement the fixed cost is found.

Measuring Composite Leverage

Degree of Total Leverage:

% Change in Net Earnings DTL % Change in Sales

The Effect of Leverage on

Profitability
How does leverage affect the EPS and ROE of a firm?
When we increase the amount of debt financing, we increase the fixed interest expense If we have a good year (BEP > kd), then we pay our fixed interest cost and we have more left over for our stockholders If we have a bad year (BEP < kd), we still have to pay our fixed interest costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE