CHAPTER 12 Leverage and Capital Structure 519
degree of total leverage (DTL)
The numerical measure of the
firm’s total leverage.
TABLE 12.7 The Total Leverage Effect
50%
Sales (in units) 20,000 30,000
Sales revenuea $100,000 $150,000
Less: Variable operating costsb 40,000 60,000 DOL1.2
Less: Fixed operating costs (^1) (^0) , (^0) (^0) (^0) (^1) (^0) , (^0) (^0) (^0)
Earnings before interest and
taxes (EBIT) $ 50,000 $ 80,000
60% DTL6.0
Less: Interest (^2) (^0) , (^0) (^0) (^0) (^2) (^0) , (^0) (^0) (^0)
Net profits before taxes $ 30,000 $ 60,000
Less: Taxes (T0.40) (^1) (^2) , (^0) (^0) (^0) (^2) (^4) , (^0) (^0) (^0) DFL5.0
Net profits after taxes $ 18,000 $ 36,000
Less: Preferred stock dividends (^1) (^2) , (^0) (^0) (^0) (^1) (^2) , (^0) (^0) (^0)
Earnings available for common $ 6,000 $ 24,000
Earnings per share (EPS) $1.20 $4.80
300%
aSales revenue$5/unitsales in units.
bVariable operating costs$2/unitsales in units.
$24,000
5,000
$6,000
5,000
300%
60%
300%
50%
60%
50%
- This approach is valid only when the same base level of sales is used to calculate and compare these values. In
other words, the base level of sales must be held constant if we are to compare the total leverage associated with dif-
ferent levels of fixed costs.
the levels of earnings per share associated with the expected sales of 20,000 units
and with sales of 30,000 units.
The table illustrates that as a result of a 50% increase in sales (from 20,000
to 30,000 units), the firm would experience a 300% increase in earnings per
share (from $1.20 to $4.80). Although it is not shown in the table, a 50%
decrease in sales would, conversely, result in a 300% decrease in earnings per
share. The linear nature of the leverage relationship accounts for the fact that
sales changes of equal magnitude in opposite directions result in EPS changes of
equal magnitude in the corresponding direction. At this point, it should be clear
that whenever a firm has fixed costs—operating or financial—in its structure,
total leverage will exist.
Measuring the Degree of Total Leverage (DTL)
The degree of total leverage (DTL)is the numerical measure of the firm’s total
leverage. It can be computed much as operating and financial leverage are com-
puted. The following equation presents one approach for measuring DTL:^11
DTL (12.8)
Percentage change in EPS
Percentage change in sales