Introduction to Finance

TA B L E 1 8 . 5
Effects of Business Risk and Financial Risk on a Simplified Income Statement
Impact of 
Business Risk 
(Top Half of 
Income Statement)
Sales revenue (equals price × quantity sold)
Less variable costs (such as labor and materials;
equals variable cost per unit × quantity)
Less fixed costs (such as rent and depreciation expenses)
Earnings before interest and taxes (operating income)
Impact of 
Financial Risk 
(Bottom Half of 
Income Statement)
Less interest expense (bank loans, bonds, other debt; a fixed
expense as it is not dependent on sales)
EBT (earnings before taxes)
Less taxes (a variable expense, dependent on EBT)
Net Income
eps = Net Income/Number of Shares
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586
C H A PT E R 1 8 Capital Structure and The Cost of Capital
Degree of Financial Leverage 
A fi rm’s fi nancial risk refl ects its interest expense, or in fi nancial jargon, its fi nancial leverage. 
A quick way to determine a fi rm’s exposure to fi nancial risk is to compute its degree of fi n-
ancial leverage. The 
degree of fi nancial leverage (DFL)
measures the sensitivity of earnings 
per share to changes in EBIT:
The equation is as follows:
DFL =
Percentage change in eps
Percentage change in EBIT
(18-10)
This defi nition means that DFL represents the percentage change in earnings per share arising 
from a 1 percent change in earnings before interest and taxes. For example, a DFL of 1.25 
means the fi rm’s eps will rise (or fall) by 1.25 percent for every 1 percent increase (or decrease) 
in EBIT; a 1 percent change in EBIT becomes magnifi ed to a 1.25 percent change in earnings 
per share.
There is a more straightforward way to compute a fi rm’s DFL that avoids handling per-
centage changes in variables. This formula is given in equation 18-11:
DFL =
EBIT
EBIT − I
=
EBIT
EBT
(18-11)
DFL equals the fi rm’s earnings before interest and taxes divided by EBIT minus interest expense, 
or earnings before taxes (EBT).
Let’s use equation 18-11 to fi nd the degree of fi nancial leverage when EBIT equals $50 
and interest expense equals $10, $20, and $0. When EBIT equals $50 and interest expense 
equals $10, DFL equals $50∕($50 – $10) = 1.25. When interest expense is $20, DFL equals 
$50∕($50 – $20) = 1.67. Higher interest expense leads to greater fi nancial risk and greater eps 
sensitivity to changes in EBIT.
When the interest expense is zero, the DFL is $50∕($50 – $0) = 1.00. That is, the per-
centage change in eps will be the same as the percentage change in EBIT. Without any fi xed 
fi nancial cost, no fi nancial leverage and no magnifi cation eff ect occur.
Total Risk
Total earnings risk, or total variability in earnings per share, is the result of combining the 
eff ects of business risk and fi nancial risk. As shown in Table 18.5, operating leverage and fi n-
ancial leverage combine to magnify a given percentage change in sales to a potentially much 
greater percentage change in earnings.
Together, operating and fi nancial leverage produce an eff ect called