Which of the following companies has the highest degree of financial leverage? Choose the best answer.
Firm A -
EBIT: $10,000,000 -
Interest Paid: $750,000 -
Total Operating Expenses: $25,000,000
Fixed Operating Expenses: $19,750,000
Firm B -
EBIT: $8,970,000 -
Interest Paid: $88,000 -
Total Operating Expenses: $20,050,000
Fixed Operating Expenses: $17,000,000
Firm C -
EBIT: $10,500,000 -
Interest Paid: $1,050,000 -
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $35,000,000
Firm D -
EBIT: $10,000,000 -
Interest Paid: $750,000 -
Total Operating Expenses: $50,000,000
Fixed Operating Expenses: $41,000,000
Firm E -
EBIT: $5,195,000 -
Interest Paid: $400,000 -
Total Operating Expenses: $35,000,000
Fixed Operating Expenses: $9,875,000
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A. B. C. D. E. F.D
The Degree of Financial Leverage (DFL) measures the percentage change in EPS that results from a given percentage change in EBIT. Financial Leverage is the second component of total leverage, along with Operating Leverage. The equation used to calculate the Degree of Financial Leverage is as follows: {DFL = [EBIT/
(EBIT - Interest Paid)]}.
In this example, Firm C has the highest DFL, with a figure of 1.11. While Firm A and D do have identical Degree of Financial Leverage calculations, the question asks which firm has the highest DFL, which is firm C. When calculating the DFL figure, remember that the answer can never be less than one, and can never be negative. In a situation where the company under examination has zero interest expense, the DFL would be equal to one; i.e. the EBIT is equal to the EBIT minus the interest expense. Another important note to remember is that in calculating the Degree of Financial Leverage, dividend payments to preferred stockholders should be included in the interest expense figure. Operating expenses are not factored into the DFL calculation, rather are used in the determination of Operating
Leverage.