Leverage and Cost of Capital

Leverage
- the effects that fixed costs have on the returns that shareholders earn
- magnify returns and risks

Operating leverage
- relationship between sales revenue and EBIT

Financial leverage
- relationship between EBIT and EPS

Total leverage
- relationship between sales revenue and EPS

operating leverage and financial leverage influence a firm's beta

breakeven point = fixed costs / contribution margin
                             = fixed costs / (price - variable costs)

When contribution margin (CM) is higher, profit rises faster
The higher the fixed costs, and low variable cost, the higher the beta

Operating leverage
- comes from mix of fixed and variable cost

			if sales up by 10%
	Lite	heavy	Lite	heavy
sales volume	10000	10000	11000	11000
price	1000	1000	1000	1000
total revenue	10000000	10000000	11000000	11000000
fixed cost	5000000	2000000	5000000	2000000
variable cost (per unit)	400	700	400	700
total cost	9000000	9000000	9400000	9700000
EBIT	1000000	1000000	1600000	1300000

Degree of Operating leverage = %ΔEBIT / %ΔSales

if sales up by 10%,
DOL of Lite = 60%/10% = 6
DOL of heavy = 30%/10% = 3
- more fixed cost , DOL increases

if DOL > 1, the firm has operating leverage

Financial leverage
- comes from use of debt

	Unlevered	levered
debt	0	10000
equity	20000	10000
asset	20000	20000
tax rate	0.4	0.4
interest rate	0.12	0.12
EBIT	3000	3000
interest(12%)	0	1200
EBT	3000	1800
tax	1200	720
NI	1800	1080
ROE	9%	11%

- more EBIT goes to investors in levered firm (as in NI + interest)

- for financially leveraged firm, NI is lower, but equity base is lower too, so ROE is higher

Basic Earning Power
BEP = EBIT/total assets
- BEP is not affected by financial leverage, because EBIT is the same whether you borrow or not
- BEP is affected by operating leverage, because change in EBIT is affected by DOL

Implications
- for leverage to be positive (increase ROE), BEP must be > rd
- for firms with high profit , use more debt, to shield the profit using debt (tax shield)