ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
THE MODULE

TITLE: LEVERAGE: OPERATING AND FINANCIAL

WHAT IS THE MODULE ALL ABOUT?

Module 5 deals with the concept of leverage of the firm particularly the operating
and financial leverage. The students will learn the difference between the so called
business risk and financial risk and their impact as to the profit of the firm. This module
also discusses the Hamada Equation and the kinds of Beta Coefficient.

LIST OF TOPICS TO BE STUDIED IN THE MODULE

 Lesson 1. Contribution Margin

 Lesson 2. Degree of Operating Leverage
 Lesson 3. Degree of Financial Leverage
 Lesson 4. Degree of Total Leverage
 Lesson 5. Hamada Equation

INTENDED LEARNING OUTCOMES (ILO)

At the end of this module, the students would be able to:

1) Learn and understand the concept of leverage of the firm.
2) Differentiate business risk and financial risk and their impact as to the profit
of the firm.
3) Discuss the Hamada Equation and the kinds of Beta Coefficient.

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
LEARNING CONTENT

LEVERAGE: OPERATING AND FINANCIAL

INTRODUCTION

It is a well-known fact that we can never eliminate risk. In a corporate aspect,

there is an inherent risk that the business operations may result to losses or worse,
the business may turn bankrupt. The risk is so called business risk of the firm. Now,
to support the capital expenditures or investments of the firm, the governing body
may resort to external financing thru issuance of equity or debt securities. In cases
where the firm issues debt securities to accumulate fund, this results to the additional
risk known as financial risk.

Lesson 1 – CONTRIBUTION MARGIN

Leverage, in business, may refer to a particular cost or expense that is

used to generate profit or income to the company. Moreover, maintaining high
degree of leverage increases the cost of capital of the firm, thereby, increasing the
bankruptcy probability and riskiness of the earning stream of the firm. Hence, ceteris
paribus, excessive leverage impairs the market value of the firm.

In addition, leverage is considered as the bridge between the risk of an

asset position and the corresponding risk of its equity. Under the fundamental
accounting equation, Asset = Liability + Equity, debt is a fixed obligation while equity
is the residual value. Hence, all gains or losses generated on assets will be closed to
equity.

Lastly, leverage as an elasticity, indicates the responsiveness of the value of

equity to changes in the value of overall assets. Hence, leverage is usually defined
as the ratio of assets to equity.

Evaluation of Business and Financial Risk

1. Business Risk – represents the inherent riskiness of a firm assuming

such firm has no debt or liability. Considering that such firm has no debt, its
Return on Equity (ROE) is equal to its Return on Assets (ROA). Business risk
depends on several factors such as demand variability, cost variability,
ability to innovate and operating leverage.

Operating Leverage (Degree of Operating Leverage) – represents the

extent to which fixed costs are used in a firm’s operations. This is also the risk
that the result of the firm’s operations may not be able to cover the fixed costs
it incurred.

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
The operating leverage shows the level of costs: fixed and variable,
within a firm: operating leverage is directly proportional to the fixed cost.
Thus, the higher the operating leverage, the higher the fixed cost. On the
contrary, the variable costs per unit decreases as operating leverage
increases. And when this happens, the contribution margin will rise.

To better appreciate the connection between the change in fixed or

variable cost to the operating leverage, the so called break-even point must be
considered. BEP is a point when the firm’s total revenue equates to the total
cost, thus the net income will be zero.

The break-even point is computed using the formula:

1. BEP = TFC / CMU

CM = Sales – Total Variable Costs
CMU = Sales – Total Variable Cost
Number of Units Sold
Where:
TFC – total fixed costs
CM – Contribution Margin
CMU – Contribution Margin per Unit

Illustrative Problem:

The Fat-bat Company is considering to produce and sell high quality stereo
speakers. The sales price would be set at 1.5 times the variable cost per unit; the
variable cost per unit is estimated to be P75.00; and fixed costs are estimated at
P1,200,000.

1. What sales volume would be required to break-even, i.e. to have EBIT=0?

CM per unit = (VC per unit x 1.5) – VC per unit

CM per unit = (P75 x 1.5) – P75
CM per unit = P37.50

BEP = TFC / CMU

BEP = P1,200,000 / P37.50
BEP = 32,000 units

2. What if the Fat-bat sold 40,000 units of stereo, how much will be the net
income?

Net Income = CM – TFC

= (CM per unit x units sold) – TFC
= (P37.50 x 40,000 units) – P1,200,000
= P1,500,000 – P1,200,000
Net Income = P300,000

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5

Lesson 2 - DEGREE OF OPERATING LEVERAGE

Aside from the break-even analysis, the profit elasticity may also be
considered in measuring the degree of operating leverage. Under this concept, DOL
(Degree of Operating Leverage) is the elasticity of Earnings Before Interest and Taxes
(EBIT) with respect to sales revenue, and reflects leverage in production. Hence, DOL
is the percentage change in operating income over the percentage change in sales.

Therefore, the Degree of Operating Leverage (DOL) may be computed using

any of the following formulas:

Illustrative Problem A:

CarWin Company has the following forecast for 2022:

Forecast sales in units 40,000

Selling price per unit P100
Variable cost per unit P70
Fixed Costs:
Manufacturing overhead P300,000
and expenses
Interest expense P50,000
EPS P8.50
Tax 40%

1. What is the amount of income after tax?

Sales (40,000 units x P100) P4,000,000

Variable cost (40,000 units x P70) 2,800,000
Contribution Margin P1,200,000
Fixed Manufacturing Overhead and Expenses ( 300,000)
Operating Income (EBIT) P 900,000
Interest expense ( 50,000)
Earnings before tax (EBT) P 850,000
Tax (340,000)
Net Income After Tax (NIAT) P 510,000

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5

2. Compute the break-even point in number of units.

BEP = TFC / CMU

= P300,000 + P50,000
P30
BEP = 11,667 units

CMU = (P4,000,000 – P2,800,000) / 40,000 units

= P1,200,000 / 40,000 units
CMU = P30

3. At sales level of 40,000 units, what is the degree of operating

leverage?

DOL = CM / EBIT
= P1,200,000 / P900,000
DOL = 1.33x

Illustrative Problem B:

Last year Barbie-Que operating income (EBIT) increased by 22% while its
peso sales increased by 15%. What is the company’s degree of operating leverage
before the increase in sales?

DOL = 22% / 15%

DOL = 1.47x

Lesson 3 - DEGREE OF FINANCIAL LEVERAGE

Financial risk represents the additional risk borne by the firm because of
the existence of debt or liabilities. Financial risk may also refer to the risk that the
company may be unable to service or settle its liabilities and as such may encounter
bankruptcy.

In accumulating funds to finance the capital expenditure, the firm may seek
external financing thru issuance of equity or debt securities. However, the firm should
consider the corresponding cost of equity and cost of debt. If the firm issues debt
securities to raise funds, the financial leverage increases due to the cost of debt.
Thus, the following are factor that influences the firm’s leverage decision:
a. Cost of debt and cost of equity
b. Capital expenditure or investments of the firm

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
Degree of Financial Leverage (DFL) is the elasticity of profits with
respect to Earnings before interest and tax (EBIT), and reflects the use of
financial leverage. There is a trade-off between operating and financial risk, so
the firms with low operating risk will have a high financial risk.

DFL represents the extent to which interest expenses are incurred.

Therefore, it can be computed using any of the following formulas:

Illustrative Problem A:

CarWin Company has the following forecast for 2022:

Forecast sales in units 40,000

Selling price per unit P100
Variable cost per unit P70
Fixed Costs:
Manufacturing overhead P300,000
and expenses
Interest expense P50,000
EPS P8.50
Tax 40%

At sales level of 40,000 units, what is the degree of financial leverage?

Solution: (refer to the solution provided under Degree of Operating Leverage

– DOL)

DFL = EBIT / EBT

= P900,000 / P850,000
DFL = 1.06x

Illustrative Problem B:

A firm has EBIT of P3.6M and debt of P15M on which it pays 8% interest.
What is its degree of financial leverage (DFL)?

Solution:
Interest charge = debt x interest rate
Interest charge = P15million x 8%
Interest charge = P1,200,000

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
EBIT P3,600,000
Less: Interest 1,200,000
EBT P2,400,000

DFL = EBIT / EBT

= P3,600,000 / P2,400,000
DFL = 1.5x

Lesson 4 - DEGREE OF TOTAL LEVERAGE

Total or combined risk represents the combined risk borne by the firm as
a consequence of using fixed costs and financing (debt). This involves the
possible inability to cover fixed costs as well as the settlement of liabilities.

The concept of degree of total leverage summarizes the relationship between

the revenue of the firm and its net income with reference to the relatively high fixed
costs and relatively low variable costs. The firm is considered as “highly levered” due
to the high level of fixed costs.

The effects of maintaining high leverage as regards profit and losses is that:
 When the sales revenue increases, the profit of the firm increases more than
proportionally because of high contribution margin (sales revenue less variable
costs) generated despite the high level of fixed costs.
 When the sales revenue decreases, there is high probability of incurring losses
because of high level of fixed costs that may not be covered by the low
contribution margin.

Total or Combined Leverage (Degree of Combined Leverage or Degree

of Total Leverage – DTL) represents the extent to which both fixed costs and
interest expenses are incurred. DTL is the so called “revenue elasticity of profits”,
thus, it is the percentage change in earnings that is caused by percentage change in
revenue. In addition, it can be expressed as the product of the degree of operating
leverage and degree of financial leverage. Therefore, it can be computed using any
of the following formulas:

Illustrative Problem A:

CarWin Company has the following forecast for 2022:

Forecast sales in units 40,000

Selling price per unit P100

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
Variable cost per unit P70
Fixed Costs:
Manufacturing overhead P300,000
and expenses
Interest expense P50,000
EPS P8.50
Tax 40%

At sales level of 40,000 units, what is the degree of combined leverage?

Solution: (refer to the solution provided under Degree of Operating Leverage

– DOL and Financial Leverage – DFL)

DCL = CM / EBT
DCL = 1,200,000 / 850,000
DCL = 1.41

OR

DCL = DOL x DFL

DCL = 1.33 x 1.06
DCL = 1.41

Lesson 5 - HAMADA EQUATION

Hamada’s Equation is derived by combining the concept of Capital Asset

Pricing Model (CAPM) with the propositions of Modigliani and Miller (M&M). Under
the CAPM, a firm’s Beta represents its inherent risk in a given market under the
assumption that the firm’s is unlevered.

Hamada Equation shows the relationship of the beta of a levered firm to that
of its unlevered counterpart. The significance of this relationship is that it allows one
to segregate the financial risk of leverage contained in the beta of a levered firm (βL)
from the beta of an unlevered firm (βU) which reflects only the business risk. Hence,
the difference between the two betas is attributable to how the firm was financed.

As the company moves from being unlevered to levered, the level of debt does
not only increase the risk borne by the creditors but also places additional risk to the
shareholders. As the company incurs a higher level of debt, this Beta is adjusted to
capture the relative riskiness of firm as affected by financial risk.

To compute for the adjusted Beta, the Hamada Equation is utilized which has
a formula of: βL = βU (1 – T)(D/E); where
βL = levered Beta
βU = unlevered Beta
D/E = debt-to-equity ratio

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
Beta unlevered (βU) is the beta coefficient of the firm without debt or firm fully
financed by equity. On the other hand, beta levered (βL) is the beta coefficient of the
firm with financial risk or debt.

Debt to equity ratio is a ratio that shows the proportion of company’s funds
financed by debt compared to funds financed by equity. This ratio is a good measure
of the financial status of the company. The higher debt to equity ratio implies that the
company is highly financed by debt or creditors, thus increases the financial risk of
the company. On the contrary, lower debt to equity ratio signifies that the contribution
from the stockholders is more than from creditors, thus the company has better
standing in terms of solvency yet it does not increase earnings through leverage.

Illustrative Problem

Shares Company is trying to estimate its optimal capital structures. Right now,
Shares has a capital structure that consists of 40% debt and 60% equity (its D/E ratio
is 0.667). The risk-free rate is 6% and the market risk premium, rm – rf, is 5%. Currently
the company’s cost of equity, which is based on the CAPM, is 14% and its tax rate is
40%. What would be the estimated cost of equity is it were to change its capital
structure to 50% equity?

Solution:
Current Cost of Equity:
ke = rf + β (MRP)
14% = 6% + β (5%)
0.05 β = 0.14 – 0.06
0.05 β = 0.08
0.05 0.05
β = 1.6

Unlevered Beta:
βL1 = βU [1 + (1 – T)(D/E)]
βL1
βU =
[1 + (1 – T)(D/E)]
1.6
βU =
[1 + (1 – 40%)(40%/60%)]
βU = 1.14

New (Levered) Beta (at debt-to-equity ratio of 50%:50%):

βL2 = βU [1 + (1 – T)(D/E)]
βL2 = 1.14 [1 + (1 – 40%)(50%/50%)]
βL2 = 1.82

New Cost of Equity using New Beta of 1.82 (at equity portion of 50%):
ke = rf + β (MRP)
ke = 6% + 1.6 (5%) = 0.14 or 14%

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5

SUMMARY OF MODULE 5 – LEVERAGE: OPERATING

AND FINANCIAL

Leverage is a ratio of a company’s loan capital (debt) to the value of its common
stock (equity). It is also the use of capital to maximum advantage. Leverage can be
operating and financial. Thus, business risk and financial risk are also considered in
the leveraging activities of the business.

References:

Anastacio, Ma. Flordeliza, [Link] (2010): Fundamentals of Financial Management (With

Industry Perspective)

Bagayao, Ivan Yannick, [Link] (2018): Financial Management Volume 1

Bagayao, Ivan Yannick (2019): Financial Management Volume 2

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
Name: _______________________________ Score: _______
Year and Section: __________ Date: ________

INTENDED LEARNING ACTIVITY

MULTIPLE CHOICE/ANALIZATION: (30 points)

Direction: Choose the best answer. Letters only. (3 points each)

1. Statement 1. Financial risk refers to the extra risk borne by the stockholders
as a result of a firm’s use of debt as compared with their risk if the firm had
used no debt.
Statement 2. If a firm borrows money, it is using financial leverage.
a. True, True
b. True, False
c. False, True
d. False, False

2. Statement 1. Other things held constant, an increase in financial leverage will

increase a firm’s market (or systematic) risk as measured as measured by its
beta coefficient.
Statement 2. Provided a firm does not use an extreme amount of debt,
operating leverage, typically affects only EPS, while financial leverage affects
both EPS and EBIT.
a. True, True
b. True, False
c. False, True
d. False, False

3. Statement 1. The trade-off theory states that capital structure decisions involve
a trade-off between the costs and benefits of debt financing.
Statement 2. It is possible for Firms A and B to have identical financial and
operating leverage, yet for Firm A to have more risk as measured by the
variability of EPS. This would occur if Firm A has more business risk than Firm
B.
a. True, True
b. True, False
c. False, True
d. False, False

4. Statement 1. In a world without taxes the optimal capital structure decisions

involve a trade-off between the costs and benefits of debt financing.
Statement 2. Other things held constant, firms with more stable and
predictable sales tend to use more debt than firms with less stables sales.
a. True, True
b. True, False

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
c. False, True
d. False, False

5. Statement 1. Other things held constant, the lower a firm’s tax rate, the more
logical it is for the firm to use debt.
Statement 2. If a firm utilizes debt financing, a 10% decline in earnings before
interest and taxes (EBIT) will result in a decline in earnings per share that is
larger than 10%, and the higher the debt ratio, the larger this difference will be.
a. True, True
b. True, False
c. False, True
d. False, False

6. Which of the following statements is correct?

a. Since debt financing raises the firm’s financial risk, increasing the target
debt ratio will always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a company’s
debt ratio will always reduce its WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal costs
of both debt and equity financing. However, this action still may raise the
company’s WACC.
d. Increasing a company’s debt ratio will typically increase the marginal costs
of both debt and equity financing. However, this action still may lower the
company’s WACC.

7. Which of the following statements is correct?

a. The capital structure that maximizes expected EPS also maximizes the
price per share of common stock.
b. The capital structure that minimizes the interest rate on debt also
maximizes the expected EPS.
c. The capital structure that minimizes the required return on equity also
maximizes the stock price.
d. The capital structure that minimizes the WACC also maximizes the price
per share of common stock.

8. Which of the following statements best describes the optimal capital structure?
a. The optimal capital structure is the mix of debt, equity and preferred stock
that maximizes the company’s earnings per share.
b. The optimal capital structure is the mix of debt, equity and preferred stock
that maximizes the company’s stock price.
c. The optimal capital structure is the mix of debt, equity and preferred stock
that minimizes the company’s cost of equity.
d. The optimal capital structure is the mix of debt, equity and preferred stock
that minimizes the company’s cost of debt.

9. The use of fixed-cost financing is referred to as

a. Operating leverage
b. Financial leverage

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT
ILOCOS SUR POLYTECHNIC STATE COLLEGE

Tagudin Campus

MODULE 5
c. A leverage buyout
d. Combined leverage

10. Which of the following is true of financial leverage?

a. It affects the sensitivity of earnings after tax to changes in sales.
b. It arises from the use of debt financing.
c. It is increased by an increase in operating leverage.
d. Both a and b

Course Code: Fin 158

Descriptive Title: SPECIAL TOPICS IN FINANCIAL Instructor: Mary Rose Supsup Abaniz
MANAGEMENT