Principles of Managerial Finance

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%

11. 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