Intro to Finance: Capital Structure - Leverage Operating, Financial Combined Leverage

What This Is

Leverage is a fundamental concept in finance that measures the degree to which a company uses debt and equity financing to fund its operations. Operating leverage refers to the use of fixed costs to generate revenue, while financial leverage refers to the use of debt to amplify returns on equity. Combined leverage is the result of both operating and financial leverage. For example, consider Apple Inc., which uses a significant amount of debt to finance its operations. If Apple's sales increase by 10%, its operating leverage will amplify this increase, but its financial leverage will also increase the risk of default.

Key Formulas & Symbols

• Operating Leverage (OL) = (?Sales - ?Fixed Costs) / ?Sales where OL = operating leverage, ?Sales = change in sales, ?Fixed Costs = change in fixed costs.
• Financial Leverage (FL) = (EBIT / (EBIT + Interest Expenses)) where FL = financial leverage, EBIT = earnings before interest and taxes, Interest Expenses = interest expenses.
• Combined Leverage (CL) = OL × FL where CL = combined leverage.
• Debt-to-Equity Ratio (D/E) = Total Debt / Total Equity where D/E = debt-to-equity ratio, Total Debt = total debt, Total Equity = total equity.
• Interest Coverage Ratio (ICR) = EBIT / Interest Expenses where ICR = interest coverage ratio.
• WACC (Weighted Average Cost of Capital) = (E/V × Re) + (D/V × Rd × (1 - T)) where WACC = weighted average cost of capital, E = market value of equity, V = total market value, Re = cost of equity, D = market value of debt, Rd = cost of debt, T = tax rate.
• Cost of Equity (Re) = Rf +-× (Rm - Rf) where Re = cost of equity, Rf = risk-free rate,-= beta, Rm = market return.
• Cost of Debt (Rd) = (1 - T) × (Coupon Rate + Default Risk Premium) where Rd = cost of debt, T = tax rate, Coupon Rate = coupon rate, Default Risk Premium = default risk premium.

Step-by-Step Calculation

1. Calculate the operating leverage (OL) of a company using the formula OL = (?Sales - ?Fixed Costs) / ?Sales. For example, if a company's sales increase by 10% and its fixed costs remain the same, the OL would be 1.
2. Calculate the financial leverage (FL) of a company using the formula FL = (EBIT / (EBIT + Interest Expenses)). For example, if a company's EBIT is $100 and its interest expenses are $20, the FL would be 0.83.
3. Calculate the combined leverage (CL) of a company using the formula CL = OL × FL. For example, if a company's OL is 1 and its FL is 0.83, the CL would be 0.83.
4. Calculate the debt-to-equity ratio (D/E) of a company using the formula D/E = Total Debt / Total Equity. For example, if a company's total debt is $100 and its total equity is $50, the D/E would be 2.
5. Calculate the interest coverage ratio (ICR) of a company using the formula ICR = EBIT / Interest Expenses. For example, if a company's EBIT is $100 and its interest expenses are $20, the ICR would be 5.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC because it reflects the current market price of the company's securities.
• Mistake: Confusing IRR and NPV ranking.
• Correction: IRR is the rate of return that makes NPV equal to zero, while NPV is the present value of future cash flows.
• Mistake: Ignoring default risk premium when calculating cost of debt.
• Correction: Default risk premium is an important component of cost of debt, as it reflects the risk of default.

Exam / CFA Tips

• Tip: Be careful when using the WACC formula, as the tax rate and default risk premium can have a significant impact on the result.
• Tip: Make sure to use the correct formula for cost of equity, as it depends on the market return and beta.
• Tip: When calculating combined leverage, make sure to use the correct formula and values for operating and financial leverage.

Quick Practice Problem

A company has a debt-to-equity ratio of 2 and an interest coverage ratio of 5. What is its financial leverage?

Answer: 0.83

Explanation: Financial leverage is calculated as EBIT / (EBIT + Interest Expenses). Given the interest coverage ratio of 5, we can assume that EBIT is 5 times the interest expenses. Therefore, financial leverage is 0.83.

Last-Minute Cram Sheet

• The dividend discount model (DDM) requires g < r – otherwise the model explodes.
• WACC = (E/V × Re) + (D/V × Rd × (1 - T))
• Cost of Equity = Rf +-× (Rm - Rf)
• Cost of Debt = (1 - T) × (Coupon Rate + Default Risk Premium)
• Operating Leverage = (?Sales - ?Fixed Costs) / ?Sales
• Financial Leverage = (EBIT / (EBIT + Interest Expenses))
• Combined Leverage = OL × FL
• Debt-to-Equity Ratio = Total Debt / Total Equity
• Interest Coverage Ratio = EBIT / Interest Expenses