Operating, Financial & Combined Leverage, and Capital Structure Theories

Explanation

Leverage quantifies the magnification of return volatility caused by fixed commitments. Operating leverage magnifies the effect of revenue swings on operating earnings (EBIT), while financial leverage magnifies the effect of EBIT fluctuations on shareholder returns (EPS).

Key points

• Financial Leverage measures fixed financing interest costs: DFL = EBIT / EBT = (% Change in EPS) / (% Change in EBIT).
• Combined Leverage: DCL = DOL · DFL = Contribution / EBT.
• Net Income (NI) Approach (Durand): Capital structure matters; increasing debt reduces WACC and raises firm value.
• Net Operating Income (NOI) Approach: WACC and total firm value remain constant regardless of debt-equity mix.
• Modigliani-Miller (MM) Theorem: In a perfect market without taxes, capital structure is irrelevant (Arbitrage proof). With corporate taxes, debt increases firm value due to interest tax shields (V_L = V_U + t_c · Debt).

Example

Code examples

// Leverage Formulations:
// Income Statement Flow:
// Sales - Variable Costs = Contribution
// Contribution - Fixed Operating Costs = EBIT
// EBIT - Interest = EBT (Earnings Before Tax)
// EBT - Taxes = EAT (Earnings After Tax)
// EAT / Number of Shares = EPS (Earnings Per Share)

// DOL = Contribution / EBIT
// DFL = EBIT / (EBIT - Interest - [Preference Dividend / (1 - Tax)])
// DCL = DOL * DFL = Contribution / (EBIT - Interest)

Exam questions

• [8 Marks] Calculate Degree of Operating Leverage, Financial Leverage, and Combined Leverage from a given corporate income statement.
• [7 Marks] Explain Modigliani-Miller (MM) hypothesis of capital structure both in the absence and presence of corporate taxes.