Degree of Financial Leverage (DFL)

Companies finance operations through debt or equity. If a company finances through equity, it can either use retained earnings or issue new shares. However, if a company issues debt in the form of bonds, it is legally required to make interest payments and pay back the principal when due.

The more debt a company issues, the greater the financial burden. __Financial risk__ refers to the risk of meeting financial obligations related to debt. Consider an all-equity firm with a total value of $1,000. There are 10 shareholders that each own 10% of the company. Which investor carries the most burden in the case of financial distress?

Not quite. There is no indication that the first investor took on a larger portion of the company. Since each investor owns the same percentage of the firm, they each take on the same amount of risk.

Correct. Since each investor owns the same percentage of the firm, they each take on the same amount of risk.

However, if the same company had a capital structure that was 50% debt and 50% equity, who would lose the most if the company went into financial distress?

Not quite. Five investors own bonds and five own equity. The debt holders would be paid first, so virtually all of the risk would be divided among the five equity holders (the stockholders).

Correct. Five investors own bonds and five own equity. The debt holders would be paid first, so virtually all of the risk would be divided among the five equity holders.

Given this, the definition of financial risk can be expanded to include the additional risk placed on stockholders as a result of the decision to finance with debt.

Financial risk can be quantified by calculating the __degree of financial leverage (DFL)__: $$\displaystyle DFL = \frac{\% \Delta \text{ Net income}}{\% \Delta \text{ Operating income}} $$ Assume you own an ice cream stand. DFL is 2.5, and operating income has decreased 5% mainly due to a drastic price increase in one of your most important inputs, the cone. What effect do you think this decrease will have on net income?

Not quite. DFL is greater than 1, so financial leverage exists in the capital structure. So there's a:

Yes! There's a:

$$\displaystyle 2.5 \times -0.05 = -0.125$$ decrease in net income. The loss is magnified due to the financial leverage. But why is that the case? Well, by using more debt financing, your ice cream stand has higher fixed costs, which increase the sensitivity of net income to changes in operating income.

In summary: [[summary]]

The first equity investor

They share the burden equally

The bondholders

The stockholders

Because DFL is a relatively low number, it decreases net income by 10.5%

Because DFL is greater than 1, it magnifies the loss and decreases net income by 12.5%

Continue

Continue