Introduction to Finance

%
10
%
= 3.50
The DFL measures the impact of fi xed fi nancial expenses and is estimated in the following way:
DFL =
EBIT
EBIT − I
Thus, DFL is equal to the following:
DFL =
$80,000
$80,000 − $20,000
=
$80,000
$60,000
= 1.33
This is the same as the percentage change in eps (46.7 percent) divided by the percentage 
change in EBIT (35 percent) in Table 18.6:
DFL =
46.7
%
35.0
%
= 1.33
Finally, the DCL can be estimated by fi nding the product of the DOL and the DFL as follows:
DCL = DOL × DFL
= 3.5 × 1.33
= 4.66
TA B L E 1 8 . 6
Effects of Leverage on the Income Statement
Next Year
This Year
10% Sales 
Decrease
10% Sales 
Increase
Net sales 
$700,000
$630,000 
$770,000
Less: variable costs (60% of sales) 
420,000
378,000 
462,000
Less: fixed costs 
200,000
200,000 
200,000
Earnings before interest and taxes 
80,000
52,000 
108,000
Less: interest expenses 
20,000
20,000 
20,000
Income before taxes 
60,000
32,000 
88,000
Less: income taxes (30%) 
18,000
9,600 
26,400
Net income 
$42,000
$22,400 
$61,600
Percent change in operating income (EBIT)
–35.0% 
+35.0%
Percent change in net income
–46.7% 
+46.7%

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588
C H A PT E R 1 8 Capital Structure and The Cost of Capital
Except for rounding, this is the same as the percentage change in eps (46.7 percent) divided by 
the percentage change in sales (10 percent): 46.7 percent/10 percent = 4.67.
By knowing the DCL factor, we can estimate next year’s change in net income (assuming no 
major change occurs in the income tax rate) by multiplying the expected percentage change in net 
sales by the DCL of 4.67. For example, a 10 percent increase in net sales will increase net income 
by 46.7 percent (10 percent times the combined leverage factor of 4.67). Combined leverage 
works in both directions, and a decline in net sales might place the fi rm in a diffi
cult fi nancial pos-
ition. A 10 percent decline in sales will be expected to reduce net income and eps by 46.7 percent.
Using operating and fi nancial leverage produces a compound impact when a change in 
net sales occurs. Thus, from a risk perspective, the fi nancial manager must use operating and 
fi nancial leverage to form an acceptable combined leverage eff ect.
For example, if a fi rm’s stockholders do not like large amounts of risk, a fi rm with a high 
DOL may attempt to keep fi nancial leverage low. In other words, it will use relatively less debt 
and more equity to fi nance its assets. Likewise, a fi rm with low business risk (that is, steady 
sales and low fi xed operating expenses), such as an electric utility, can support a higher DFL 
and use relatively more debt fi nancing. There is no evidence that fi rms adjust their DOLs and 
DFLs to match some standard degree of combined leverage, but their relationship does imply 
a potential trade-off between a fi rm’s business and fi nancial risk.
18.8
Insights From Theory and Practice
An insight from our discussion of combined leverage is that a fi rm with greater business risk 
may be inclined to use less debt in its capital structure, while a fi rm with less business risk 
may use more debt in its capital structure. Theories of fi nancial researchers have shed light on 
additional infl uences on the capital structure decision.
Taxes and Nondebt Tax Shields 
Interest on debt is a tax-deductible expense whereas stock dividends are not; dividends are 
paid from after-tax dollars. This gives fi rms a tax incentive to use debt fi nancing.
In reality, the benefi ts of tax-deductible debt have limits. Business risk leads to EBIT 
variations over time, which can lead to uncertainty about the fi rm’s ability to fully use future 
interest deductions. For example, if a fi rm has a negative or zero operating income, an interest 
deduction will provide little help; it just makes the pretax losses larger. Firms in lower tax 
brackets have less tax incentive to borrow than those in higher tax brackets.
In addition, fi rms have other tax-deductible expenses besides interest. Various cash and 
noncash expenses, such as depreciation, R&D, and advertising expenses, can reduce operating 
income. Thus, the tax deductibility of debt becomes less important to fi rms with large nondebt 
tax shields. Foreign tax credits, granted by the U.S. government to fi rms that pay taxes to for-
eign governments, also diminish the impact of the interest deduction.
Bankruptcy Costs 
The major drawback to debt in the capital structure is its legal requirement for timely pay-
ment of interest and principal. As the debt/total asset ratio rises, or as earnings become more 
volatile, the fi rm will face higher borrowing costs, driven upward by bond investors requiring 
higher yields to compensate for additional risk.
A rational marketplace will evaluate the probability and associated costs of bankruptcy for 
a levered fi rm.