Degree of Financial Leverage

[wxyz]

The same page in Stella's book Pretax Income=(EBIT - INT):

DFL = EBIT / Pretax Income

and

DFL = %delta in Pretax Income / %delta inEBIT

how can they be the the same by inversing the Numerator and denomerator from two equation, just w/o a %delta?

 

[jamespucyk]

I'm pretty sure DFL = % change in EPS/ % Change in Ebit. Regardless, it measures how much EPS grows with a change in EBIT, based upon the assumption of more debt. More profit flows through to the shareholders.

I.e. Consider a company with an EBIT of $100, last year, that is tax exempt with 10 shares outstanding. If EBIT increases to $200 under a no debt situation EPS increases
by $10 or 100%. I.e.
EPS = 100/10 = 10
EPS' = 200/20 = 20

Now consider a Debt situation. If the company issues bonds and has to pay $50 in the form of interest each, they may have issued half as many shares or have only 5 outsatnding. If in this case EBIT increases from 100 to 200 dollars
EPS = 100-50/5 = 10
EPS' = 200-50/5 = 30

This indicates that the company is more levered and more profit flows through to shareholders.



Edited 2 time(s). Last edit at Wednesday, April 19, 2006 at 12:24AM by jamespucyk.

 

[wxyz]

my concern is why they are equivalent, by reverse the num and denom, people can check Stella's study guide 11-94, or Stella's Lecture Note 11-48

 

[jamespucyk]

It's mathematically correct, and I don't have the time nor the patience to rehash the appendix. Also, there is no reversal of the denominator, it's a percentage change, which is not equatible to EBIT/EBIT-I (which is EBIT/Pre Tax Income) = (%-Change EPS/%-change EBIT) and if you can't get that I would go over that chapter with a fine toothed comb.

 

[hellosubhash]

Hi,

It goes this way.............

Assume Pretax Incomes Old & New to be Po & P1 respectively.
Similarly EBIT Old & New to be Eo & E1.

DFL = %Change in Pre-Tax Income / %Change in EBIT
= [(P1 - Po)/Po] / [(E1 - Eo)/Eo]
= Eo/Po [Since (P1 - Po) = (E1 - Eo)]

See the following example for clarifications.

Capital structure: Equity = 50,000 & Debt = 50,000 @ 10%


ITEM , Year 1 & Year 2

EBIT , 100,000 & 150,000

Interest Expense , (5,000) & (5,000)

Profit before Tax , 85,000 & 135,000

Tax @ 40 % , 34,000 & 54,000

Net Profit after tax , 51,000 & 81,000


Notice that since absolute change in Profit before Tax & EBIt is the same here (because Debt Capital is not changed, thus no change in Interest expense) the DFL formula can further be converted to EBIT/Profit before Tax.

DFL = % cahnge in Pretax income / % change in EBIT
= 58.824 / 50.00
= 1.1765

Again, DLF = EBIT / Pretax income
= 100,000 / 85,000
= 1.1765


Hope this helps.



Edited 1 time(s). Last edit at Thursday, April 20, 2006 at 05:04AM by hellosubhash.