Introductory Corporate Finance: Leverage - Total Leverage, Degree of Total Leverage, DTL = DOL × DFL

What This Is

Total leverage, also known as degree of total leverage (DTL), measures a company's sensitivity to changes in sales and interest rates. It is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). For example, consider a company with EBIT of $100M, interest expense of $20M, and sales of $1B. If the company's sales increase by 10%, its EBIT will increase by $10M (DOL), and its interest expense will increase by $2M (DFL), resulting in a total increase in net income of $12M.

Key Formulas & Models

• DTL = DOL × DFL – total leverage; measures net income sensitivity to sales and interest rates.
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage; measures EBIT sensitivity to sales.
• DFL = (1 + r) / (1 + r - b) – degree of financial leverage; measures net income sensitivity to interest rates.
• r = (I / D) – cost of debt; interest expense divided by debt.
• b = (E / D) – debt-to-equity ratio.
• Q = (P - V) / F – contribution margin ratio; sales minus variable costs divided by fixed costs.
• P = Sales – sales revenue.
• V = Variable Costs – costs that vary directly with sales.
• F = Fixed Costs – costs that remain the same regardless of sales.
• I = Interest Expense – interest paid on debt.
• E = Equity – shareholders' equity.

Step-by-Step Calculation

1. Calculate the contribution margin ratio (Q) using the company's sales and variable costs.
2. Calculate the degree of operating leverage (DOL) using the contribution margin ratio and the company's fixed costs.
3. Calculate the cost of debt (r) using the company's interest expense and debt.
4. Calculate the debt-to-equity ratio (b) using the company's debt and equity.
5. Calculate the degree of financial leverage (DFL) using the cost of debt and the debt-to-equity ratio.
6. Calculate the total leverage (DTL) by multiplying the degree of operating leverage and the degree of financial leverage.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC to reflect the company's current market position.
• Example: A company has a book value of $100M and a market value of $200M. Using book value would result in a WACC of 10%, while using market value would result in a WACC of 5%.
• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
• Example: A company has a flotation cost of $10M and a market value of $200M. Ignoring flotation costs would result in a WACC of 5%, while including flotation costs would result in a WACC of 6%.
• Mistake: Confusing sunk cost with opportunity cost.
• Correction: Use opportunity cost to reflect the true cost of a decision.
• Example: A company has a sunk cost of $100M and an opportunity cost of $50M. Using sunk cost would result in a decision to keep the project, while using opportunity cost would result in a decision to cancel the project.

Exam / CFA Tips

• Tip: Be careful when using M&M Proposition I (no taxes) and M&M Proposition II (with taxes) to calculate WACC.
• Tip: Understand the difference between IRR and NPV ranking.
• Tip: Be aware of the dividend irrelevance theorem and the bird-in-hand theorem.

Quick Practice Problem

A company has EBIT of $10M, interest of $2M, tax of 25%, and sales of $100M. Calculate the degree of financial leverage (DFL).

Answer: DFL = (1 + 0.1) / (1 + 0.1 - 0.25) = 1.25 / 0.75 = 1.67

Explanation: The company's DFL is 1.67, meaning that for every 1% increase in sales, the company's net income will increase by 1.67%.

Last-Minute Cram Sheet

• DTL = DOL × DFL – total leverage; measures net income sensitivity to sales and interest rates.
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage; measures EBIT sensitivity to sales.
• DFL = (1 + r) / (1 + r - b) – degree of financial leverage; measures net income sensitivity to interest rates.
• r = (I / D) – cost of debt; interest expense divided by debt.
• b = (E / D) – debt-to-equity ratio.
• Q = (P - V) / F – contribution margin ratio; sales minus variable costs divided by fixed costs.
• P = Sales – sales revenue.
• V = Variable Costs – costs that vary directly with sales.
• F = Fixed Costs – costs that remain the same regardless of sales.
• I = Interest Expense – interest paid on debt.
• E = Equity – shareholders' equity.
• WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.