Introductory Corporate Finance: Leverage Financial Leverage Degree of Financial Leverage DFL ΔEPS ΔEBIT EBIT EBIT I PD1T

What This Is

Financial leverage, also known as degree of financial leverage (DFL), measures a company's sensitivity to changes in its earnings before interest and taxes (EBIT). It's a crucial concept in corporate finance as it helps investors and analysts understand how a company's capital structure affects its profitability. For instance, let's consider Tesla, Inc. (TSLA). Suppose Tesla's EBIT increases by 20% due to higher sales, and its interest expenses remain constant at $100 million. If its EBIT is $500 million, the DFL would be 20% / 20% = 1, indicating that for every 1% change in EBIT, the company's earnings per share (EPS) will change by 1%.

Key Formulas & Models

• DFL = %ΔEPS / %ΔEBIT = EBIT / (EBIT – I – (PD/(1–T))) – degree of financial leverage; measures EPS sensitivity to EBIT changes.
• %ΔEPS: percentage change in earnings per share.
• %ΔEBIT: percentage change in earnings before interest and taxes.
• EBIT: earnings before interest and taxes.
• I: interest expenses.
• PD: preferred dividend payments.

• T: corporate tax rate.

• DFC = (D/V) / (1 – (D/V)) – degree of financial commitment; measures debt-to-equity ratio.

• D: total debt.

• V: total value of the firm.

• TIE = (D/V) / (1 – (D/V)) × (1 – T) – tax interest effect; measures the impact of debt on taxable income.

• D: total debt.
• V: total value of the firm.

• T: corporate tax rate.

• WACC = wd × rd(1‑T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.

• wd: weight of debt.
• rd: cost of debt.
• T: corporate tax rate.
• wps: weight of preferred stock.
• rps: cost of preferred stock.
• we: weight of equity.

• re: cost of equity.

• DOL = Q(P‑V) / (Q(P‑V)‑F) – degree of operating leverage; measures EBIT sensitivity to sales.

• Q: quantity sold.
• P: price per unit.
• V: variable costs per unit.
• F: fixed costs.

Step-by-Step Calculation

1. Calculate EBIT: Earnings before interest and taxes.
2. Calculate interest expenses (I): Total debt × cost of debt.
3. Calculate preferred dividend payments (PD): Total preferred stock × preferred dividend rate.
4. Calculate corporate tax rate (T): Assumed to be 25% in most cases.
5. Plug in values into the DFL formula: DFL = EBIT / (EBIT – I – (PD/(1–T))).
6. Interpret the result: A higher DFL indicates that the company's EPS is more sensitive to changes in EBIT.

Common Mistakes

• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs in the cost of debt, as they represent the costs associated with issuing new debt.

• Counterexample: Suppose a company issues $100 million in debt with a flotation cost of 2%. The correct cost of debt would be 8% + 2% = 10%.

• Mistake: Using book value instead of market value for WACC.

• Correction: Use market value for equity and debt, as it reflects the current market price of these securities.

• Counterexample: Suppose a company has a book value of equity of $100 million but a market value of $150 million. The correct WACC would use the market value of $150 million.

• Mistake: Confusing sunk cost with opportunity cost.

• Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs represent the benefits that could have been obtained from alternative uses of resources.
• Counterexample: Suppose a company invested $100 million in a project that has already been completed. The sunk cost is $100 million, but the opportunity cost is the potential return on investment that could have been obtained from alternative projects.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).

• Why: M&M Proposition I states that firm value is independent of capital structure, while M&M Proposition II states that firm value increases with debt due to the interest tax shield.

• Tip: Understand the difference between IRR and NPV ranking.

• Why: IRR ranking prioritizes projects with higher internal rates of return, while NPV ranking prioritizes projects with higher net present values.

• Tip: Be able to explain the dividend irrelevance theorem.

• Why: The dividend irrelevance theorem states that a company's dividend policy does not affect its share price, as investors can simply reinvest dividends to achieve the same return.

Quick Practice Problem

A company has EBIT of $10 million, interest expenses of $2 million, and a corporate tax rate of 25%. Compute the degree of financial leverage (DFL).

Answer: DFL = $10 million / ($10 million – $2 million – ($1 million / (1 – 0.25))) = 1.33

Explanation: The company's EPS is 1.33 times more sensitive to changes in EBIT due to its debt financing.

Last-Minute Cram Sheet

1. DFL = %ΔEPS / %ΔEBIT = EBIT / (EBIT – I – (PD/(1–T))) – degree of financial leverage.
2. ⚠️ In M&M Proposition I (no taxes), firm value is independent of capital structure.
3. WACC = wd × rd(1‑T) + wps × rps + we × re – weighted average cost of capital.
4. DOL = Q(P‑V) / (Q(P‑V)‑F) – degree of operating leverage.
5. TIE = (D/V) / (1 – (D/V)) × (1 – T) – tax interest effect.
6. DFC = (D/V) / (1 – (D/V)) – degree of financial commitment.
7. Book value ≠ Market value for WACC calculations.
8. Sunk cost ≠ Opportunity cost.
9. IRR ≠ NPV ranking.
10. Dividend irrelevance theorem states that dividend policy does not affect share price.