Question

how even healthy corporations select their DFL with impunity

Answer 1

What Is a Degree of Financial Leverage - DFL?

A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).

The use of financial leverage varies greatly by industry and by the business sector. There are many industry sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by many companies in these sectors has played a paramount role in forcing a lot of them to file for Chapter 11 bankruptcy.

Examples include R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co (A&P) (2010) and Midwest Generation (2012). Moreover, excessive use of financial leverage was the primary culprit that led to the U.S. financial crisis between 2007 and 2009. The demise of Lehman Brothers (2008) and a host of other highly levered financial institutions are prime examples of the negative ramifications that are associated with the use of highly levered capital structures.

Example of How to Use DFL

Consider the following example to illustrate the concept. Assume hypothetical company BigBox Inc. has operating income or earnings before interest and taxes (EBIT) of $100 million in Year 1, with interest expense of $10 million, and has 100 million shares outstanding. (For the sake of clarity, let’s ignore the effect of taxes for the moment.)

EPS for BigBox in Year 1 would thus be:

Operating income of 100 million - 10 million interst expense / 100 million share outstanding =0.9

The degree of financial leverage (DFL) is:

100 million / 100 million - 10 million = 1.11

This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.

Now assume that BigBox has a 20% increase in operating income in Year 2. Notably, interest expenses remain unchanged at $10 million in Year 2 as well. EPS for BigBox in Year 2 would thus be:

operating income of 120 million - 10 million / 100 million share outstanding = 1.1

In this instance, EPS has increased from 90 cents in Year 1 to $1.10 in Year 2, which represents a change of 22.2%.

This could also be obtained from the DFL number = 1.11 x 20% (EBIT change) = 22.2%.

If EBIT had decreased instead to $70 million in Year 2, what would have been the impact on EPS? EPS would have declined by 33.3% (i.e., DFL of 1.11 x -30% change in EBIT). This can be easily verified since EPS, in this case, would have been 60 cents, which represents a 33.3% decline.