Subject 2. Financial Risk and Financial Leverage

Financial risk is the additional risk placed on the common stockholders as a result of the decision to use fixed-income securities (debt and preferred stock). Increases in financial leverage (the use of fixed-income securities) increases financial risk and the expected return of stockholders, due to the obligation of servicing the fixed interest payments.

The questions are: Is the increased rate of return sufficient to compensate shareholders for the increased risk? What is the optimal financial structure to maximize stock price and the firm's value?

Financial risk depends on two factors:

  • Cash flow volatility. The more volatile (stable) a firm's cash flows, the higher (lower) the financial risk.
  • Financial leverage. The higher the financial leverage, the higher the financial risk.

As a general proposition, financial leverage raises the expected rate of return, but at the cost of increased financial risk (and thus total risk). So, you are faced with a trade-off: if you use more financial leverage, you increase the expected rate of return, which is good, but you also increase risk, which is bad.

The degree of financial leverage (DFL) measures the financial risk.

It shows how a given percentage change in EBIT per share will affect EPS.

The equation above is developed as follows:


where:
I = interest paid
T = marginal tax rate
N = number of shares outstanding

I is a constant so ΔI = 0, therefore:

Now the percentage change in EPS is the change in EPS divided by the original EPS, which is:

DFL is defined as the percentage change in earnings per share (EPS) divided by the percentage change in EBIT.

Consider a company with EBIT = $100,000 and interest = $20,000. Its DFL = 100,000 / (100,000 - 20,000) = 1.25. Therefore, a 100% increase in EBIT would result in a 125% increase in EPS.

Unlike operating leverage, the degree of financial leverage is most often a choice by the company's management. Companies with a higher ratio of tangible assets to total assets may have higher degrees of financial leverage because lenders may feel more secure that their claims would be satisfied in the event of a downturn.

User Contributed Comments 11

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thud: How come EBIT = [Q(P - V)] in the business risk section and in the financial risk section it's [Q(P - V) - F]???
xiong: Q (P - V) is the percentage change in EBIT. It has nothing to do with F. Q (P - V) - F is EBIT itself.
jd2442424: The derivation of DFL stops short one step before the end. You also need to divide percent change in EBIT by the percent change in EPS ( delta EBIT / (EBIT - I) ) to get EBIT / (EBIT - 1).
chris76: Q(P-V) is not the percentage change in Ebit...Nonetheless both formulas as presented are correct (a little algebra will confirm this)
johntan1979: Towards the end of the notes, it is stated that "DFL is the %change in EPS divided by the %change in EBIT."

I thought DFL = %change in NI / %change in EBIT?

NI is definitely NOT = EPS, and I don't think they are interchangeable.
johntan1979: Hmmm... just read from Kaplan's Schweser notes that the two are OK to be used interchangeably for DFL.

So confusing! :(
gill15: I just read the CFA curriculum book...just easier sometimes
RamaG: @jonathan : EPS = NI / # of share outstanding , since share float is constant , % change in EPS = % change in NI, so are interchangeable when considering % change
Shaan23: This operating profit thing is confusing. If you do Q.5 in the last section or one of those Q's. We found operating profit for a question and used

Q(P - V)

but in this section it uses FC as well
khalifa92: you guys wake up
Q(P-VC) or Q(P-VC) - F are mentioned in two different formulas with two different understanding
the first one is the relation between operating profit to changes in unit sold
the second one includes the first formula and moves down in the income statemet to take measure of the financial cost which leads to EBIT and relate it to net income and thus net income which in the end becomes all money the company can do whatever it wants with can become used to calculate EPS if they want to distribute it or keep it as retained earning thus they are interchangeable.
khalifa92: but iam more confused because the second part of this LOS isnt in the book so ill ignore it for now.