Question

The degree of financial leverage (DFL) is a relative measure of risk. If Corporation A has a DFL of 1.75 and Corporation B has a DFL of 83 describe where both corporations are to their financial breakeven point and explain which corporation (A or B) has the highest level of risk.

Answer 1

there are two formulas that measure the degree of financial leverage:

DFL = EBIT / (EBIT - interest)

DFL = % change in net income / % change in EBIT

Corporation A has a DFL of 1.75 which means that interests represent approximately 43% of EBIT.

if we assume EBIT = 100

1.75 = 100 / 100 - i

100 - i = 100 / 1.75

100 - i = 57.14

i = 100 - 57.14 = 42.86

financial break even point is where EBIT = interest expense

in this case, corporation A can be considered healthy because its EBIT is much higher than their interest expense.

Corporation B has a DFL of 83 which means that interests represent approximately 98.8% of EBIT.

if we assume EBIT = 100

83 = 100 / 100 - i

100 - i = 100 / 83

100 - i = 1.2

i = 100 - 1.2 = 98.8

financial break even point is where EBIT = interest expense

in this case, corporation B can be considered extremely leveraged because its EBIT barely covers their interest expense.

Corporation B is a much riskier investment than corporation A since its EBIT is almost at financial break even point