Principles of Managerial Finance

Case 1 A 40% increasein EBIT (from $10,000 to $14,000) results in a

100% increasein earnings per share (from $2.40 to $4.80).

Case 2 A 40% decreasein EBIT (from $10,000 to $6,000) results in a

100% decreasein earnings per share (from $2.40 to $0).

The effect of financial leverage is such that an increase in the firm’s EBIT

results in a more-than-proportional increase in the firm’s earnings per share,

whereas a decrease in the firm’s EBIT results in a more-than-proportional

decrease in EPS.

Measuring the Degree of Financial Leverage (DFL)

The degree of financial leverage (DFL)is the numerical measure of the firm’s

financial leverage. Computing it is much like computing the degree of operating

leverage. The following equation presents one approach for obtaining the DFL.^9

DFL  (12.6)

Whenever the percentage change in EPS resulting from a given percentage change

in EBIT is greater than the percentage change in EBIT, financial leverage exists.

This means that whenever DFL is greater than 1, there is financial leverage.

Percentage change in EPS



Percentage change in EBIT

CHAPTER 12 Leverage and Capital Structure 517

degree of financial leverage
(DFL)
The numerical measure of the
firm’s financial leverage.

TABLE 12.6 The EPS for Various EBIT Levelsa

Case 2 Case 1

40% 40%

EBIT $6,000 $10,000 $14,000

Less: Interest (I)  (^2) , (^0)  (^0)  (^0)   (^2) , (^0)  (^0)  (^0)   (^2) , (^0)  (^0)  (^0) 
Net profits before taxes $4,000 $ 8,000 $12,000
Less: Taxes (T0.40)  (^1) , (^6)  (^0)  (^0)   (^3) , (^2)  (^0)  (^0)   (^4) , (^8)  (^0)  (^0) 
Net profits after taxes $2,400 $ 4,800 $ 7,200
Less: Preferred stock dividends (PD)  (^2) , (^4)  (^0)  (^0)   (^2) , (^4)  (^0)  (^0)   (^2) , (^4)  (^0)  (^0) 
Earnings available for common (EAC) $ 0 $ 2,400 $ 4,800
Earnings per share (EPS) $0 $2.40 $4.80
100% 100%
aAs noted in Chapter 1, for accounting and tax purposes, interest is a tax-deductible expense,whereas divi-
dends must be paid from after-tax cash flows.
$4,800
1,000
$2,400
1,000
$0
1,000

9. This approach is valid only when the same base level of EBIT is used to calculate and compare these values. In
   other words, the base level of EBIT must be held constant to compare the financial leverage associated with different
   levels of fixed financial costs.