MAGNIFIER OF EARNINGS

Leverage
 Leverage is the extent to which fixed costs are used in a
company’s cost structure.
Operating Leverage
 Fixed Costs that are operating costs create operating leverage.
 Example of operating fixed costs are depreciation, rent etc.
Financial Leverage
 Fixed costs that are financial fixed costs create financial
leverage.
 Example of financial fixed cost is interest.
 Impulse Robotics Malvey Aerospace

Revenues $1,000,000 $1,000,000

Operating costs 700,000 750,000

Operating income $300,000 $250,000

Financing expense 100,000 50,000

Net income $200,000 $200,000

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

 Degree of leverage helps in assessing a company’s risk and return
characteristics.
 Analysts may able to interpret a company’s business and future
prospects from management’s decisions about the use of leverage.
 Understanding company’s use of leverage help analysts in
forecasting cash flows and in selecting appropriate discount rate.

Greater
Greater use
Greater Risk discount
of Leverage
rate applied
 Cost structure of Company
 Variable Costs: Fluctuate with the level of production and
sales. Example: cost of materials, cost of finished products
etc.
 Fixed Costs: Expenses that are same regardless of the
production and sales of the company. Example: rent, salary,
depreciation etc.

Impulse Robotics Malvey Aerospace
Number of units produced and sold
Sales price per unit
Variable cost per unit
Fixed operating cost
Fixed financing expense
Notes: if the number of units produced and
sold is different from 100,000, the net
income of the two companies diverges. If
50,000 units are produced and sold,
Impulse Robotics has a loss of $200,000
100,000 100,000
and Malvey Aerospace has $0 earnings. If,
on the other hand, the number of units
$10 $10
produced and sold is 200,000, Impulse
Robotics earns $1 million whereas Malvey
$2 $6
Aerospace earns $600,000. In other words,
$500,000 $150,000
the variability in net income is greater for
Impulse Robotics, which has higher fixed
$100,000 $50,000 costs in terms of both fixed operating costs
and fixed financing costs.

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

Sales Risk
 Uncertainty with respect to the price and quantity of goods and services.
Operating Risk
 Risk attributed to operating cost structure.
 The greater the fixed operating costs relative to variable operating costs,
the greater the operating risk.
Business Risk (Sales risk + Operating Risk):
 Risk associated with operating earnings.
 Operating earnings are risky because total revenues are risky and costs of
producing revenues are risky.
 Business risk is the combination of sales risk and operating risk.
 Ratio of percentage change in operating income to the percentage change
in units sold.

 If DOL at a given level of sales is 2, then what does it mean?

 It means 1 percent increase in unit sales from that level would be expected
to result in a 2 percent increase in operating income.
 Operating Income
 Revenue minus total operating costs.

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

Per unit Contribution Margin
 The amount that each unit sold contributes to covering fixed costs
(Difference between price per unit and variable cost per unit.
 Per unit contribution margin multiplied by the quantity sold is the
contribution margin.
See Example 1

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

 DOL is different at different numbers of units produced and sold.

More sensitive
Greater use of
operating
Fixed costs Greater
income to
relative to operating risk
changes in units
variable costs
sold
 Financial Risk
 Risk associated with how a company finances its operations.
Degree of Financial Leverage

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

 Degree of financial leverage is a choice of the company’s

management.
 Companies with relative high degree of tangible assets to total assets
may be able to use high degree of financial leverage because in the
event of a default the lenders can have a solid claim on the company’s
assets. As a result, lenders get more confidence in such companies.
See Example 2 & 3
 Combining degree of operating leverage with degree of financial leverage.
 A measure of sensitivity of net income to changes in the number of units
produced and sold.

Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

 DTL is different depending on the number of units produced and sold.

See Example 4
 Breakeven Point: Number of units produced and sold at which the
company’s net income is zero.

 Operating Breakeven Point: Number of units produced and sold at which

the company’s operating profit is zero.

See Exhibit 15 Source: CFA Level I Corporate Finance and Portfolio Management Curriculum

See Example 5
 Creditors and stockholders bear different risks because they have different
rights and responsibilities.
 Creditors get pre-determined returns and principals back when due,
regardless of the profitability of the firm.
 Stockholders are residual claimant, meaning they get what is left over after
all expenses, including interests paid to creditors, have been paid.
 The use of greater amounts of debt in the capital structure can raise both
the cost of debt and the cost of equity capital.
 The higher the percentage of debt, the riskier the debt, hence the higher
interest rate creditors will charge.
 In general, increasing the use of debt increases the expected rate of return,
but more debt also means that firm’s stockholders must bear more risk. The
cost of equity capital must be higher now than before.
 Creditorshave priorities over stockholders in a bankruptcy
proceeding. When a firm files for bankruptcy, its leverage often
determines the final outcome.
 Reorganization: Firm with high leverage uses bankruptcy laws and
protection to reorganize its capital structure to remain in business.
 Liquidation: Firm with high operating leverage that cannot use
bankruptcy protection will terminate the business. All assets are sold
and distributed to the holders of claims of the organization, and no
corporate should survive. Stockholders generally lose all values in
such a case, and creditors typically receive a portion of their capital.
 Y
1. If two companies have identical unit sales volume and
operating risk, they are most likely to also have identical:
 A. Sales risk.
 B. Business risk.
 C. Sensitivity of operating earnings to changes in the number of
units produced and sold.
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2. Degree of operating leverage is best described as a
measure of the sensitivity of:
 A. net earnings to changes in sales.
 B. fixed operating costs to changes in variable costs.
 C. operating earnings to changes in the number of units
produced and sold.
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3. The business risk of a particular company is most
accurately measured by the company’s:
 A. debt-to-equity ratio.
 B. efficiency in using assets to generate sales.
 C. operating leverage and level of uncertainty about
demand, output prices, and competition.
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4. The Fulcrum Company produces decorative swivel platforms
for home televisions. If Fulcrum produces 40 million units, it
estimates that it can sell them for $100 each. Variable production
costs are $65 per unit and fixed production costs are $1.05
billion. Which of the following statements is most accurate?
Holding all else constant, the Fulcrum Company would:
 A. generate positive operating income if unit sales were 25
million.
 B. generate 20 percent more operating income if unit sales were
5 percent greater than 40 million.
 C. have less operating leverage if fixed production costs were
10 percent greater than $1.05 billion.
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5. Myundia Motors now sells 1 million units at ¥3,529 per
unit. Fixed operating costs are ¥1,290 million and variable
operating costs are ¥1,500 per unit. If the company pays
¥410 million in interest, the levels of sales at the operating
breakeven and breakeven points are, respectively:
A. ¥1,500,000,000 and ¥2,257,612,900.
B. ¥2,243,671,760 and ¥2,956,776,737.
C. ¥2,975,148,800 and ¥3,529,000,000.
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6. The classification of risk arising from the mixture of variable and
fixed costs is:
A. sales risk.
B. financial risk.
C. operating risk.
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7. The degree of total leverage is:
A. the percentage change in net income divided by the percentage
change in units sold.
B. the percentage change in operating income divided by the
percentage change in units sold.
C. the percentage change in net income divided by the percentage
change in operating income.
THANK YOU