[MattCPA18]

Im taking BEC on May 22 so I need help understanding some topics, mainly in B3.

Can someone please explain to me the formulas for the Degree of Operating and Financial Leverage. The book is saying the formula is one thing and the questions are using a completely different method. For example explaining the terms EBIT & EPS. It just isn’t clicking for me.

Also I think Im starting to grasp the cost of debt concepts but just to confirm,

– is the cost of debt (pre-tax), risk-free rate of return, & the required rate of return all the same thing?

– is the cost of equity and the cost of retained earnings both found by using the formula kre = krf + b(km – krf) ?

– how is the “weighted average cost of debt” different from just “cost of debt”?

I appreciate the help. Thanks!

AUD – Passed

Reg – Passed

[M.O.D.]

Cost of debt is the cost of issuing bonds, or loans. This would be weighted depending on the various bonds and loans.

Required rate of return is a company internal rate for deciding which projects to pursue.

Risk-free rate is the rate on T-bills.

The formula is the CAPM formula for determining the cost of equity using market valuation of stock prices. It can also apply to the cost of using retained earnings (since it is considered equity as well), but keep in mind there are no issuing costs to using RE.

There are various formulas for operating and financial leverage, not sure which ones you mean.

Operating leverage means the company is investing in fixed assets (factories) to mass produce. The advantage is greater volume but the risk is greater fixed costs and expenses (depreciation).

Financial leverage means the company is using increased debt financing instead of equity financing. If business is good it means that more profits (and control) flow to common shareholders. The disadvantage is that in bad times, the company is saddled with interest expenses and principal payments which could bankrupt the company. Equity investment need not be paid back like debt must.

EPS is earnings per share calculated as basic and/or diluted (FAR material)

EBIT = earnings before interest and taxes. This is used to measure a company's revenues as if it had no debt to service.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[M.O.D.]

Cost of debt is the cost of issuing bonds, or loans. This would be weighted depending on the various bonds and loans.

Required rate of return is a company internal rate for deciding which projects to pursue.

Risk-free rate is the rate on T-bills.

The formula is the CAPM formula for determining the cost of equity using market valuation of stock prices. It can also apply to the cost of using retained earnings (since it is considered equity as well), but keep in mind there are no issuing costs to using RE.

There are various formulas for operating and financial leverage, not sure which ones you mean.

Operating leverage means the company is investing in fixed assets (factories) to mass produce. The advantage is greater volume but the risk is greater fixed costs and expenses (depreciation).

Financial leverage means the company is using increased debt financing instead of equity financing. If business is good it means that more profits (and control) flow to common shareholders. The disadvantage is that in bad times, the company is saddled with interest expenses and principal payments which could bankrupt the company. Equity investment need not be paid back like debt must.

EPS is earnings per share calculated as basic and/or diluted (FAR material)

EBIT = earnings before interest and taxes. This is used to measure a company's revenues as if it had no debt to service.

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[MattCPA18]

The formulas that book says are:

DOL = % Change in EBIT / % Change in Sales

DFL = % Change in EPS / % change in EBIT

DCL = % change in EPS / % Change in Sales

and regarding the cost of debt, required rate of return, & risk free rate …. what I mean is are all three used in the CAPM formula as “krf”

My problem has been the use of synonymous terms and trying to pick the correct numbers out of the problem

[M.O.D.]

is DCL degree of combined leverage?

I think my explanations are clear enough. First understand the concept then apply formulas to compare companies or situations.

Krf is only the risk-free rate (T-bills). rf stands for risk free. It cannot be the company's cost of debt because the company is not the US Treasury.

The required rate of return for equity investors is the result of the CAPM formula.

Maybe you should take one question, or concept at a time…

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[M.O.D.]

is DCL degree of combined leverage?

I think my explanations are clear enough. First understand the concept then apply formulas to compare companies or situations.

Krf is only the risk-free rate (T-bills). rf stands for risk free. It cannot be the company's cost of debt because the company is not the US Treasury.

The required rate of return for equity investors is the result of the CAPM formula.

Maybe you should take one question, or concept at a time…

BA Mathematics, UC Berkeley
Certificates in CPA and EA preparation, College of San Mateo
CMA I 420, II 470
FAR 91, AUD Feb 2015 (Gleim self-study)

[Anonymous]

For leverages, those formulas are correct.

But in the MCQ, sometimes they give different variables rather than EBIT, EPS, or change in sales.

So you can think about the concept like M.O.D said:

DOL = degree of fixed costs over variable costs (FC/VC)

DFL = degree of debt over equity (Debt/Equity)

WACC (Weighted Average Cost of Capital) is (Cost of Equity x % equity in capital structure) + (Weighted average cost of debt x % debt in capital structure).

Weighted average cost of debt is synonymous with weighted average interest rate AFTER tax, Yield to maturity rate after tax, market rate after tax, or effective interest rate after tax. (same thing but could show up as different terms)

Cost of debt is not the same as risk free rate.

CAPM is one method they could ask for to find the cost of RE, and yeah you use it to find the cost of equity (don't forget to multiply it with the % of equity in structure also if you are finding WACC).

I'm not sure which MCQ you are referring to, but if you have the question #, I could try to help you out.

Hope that helps.

[Anonymous]

For leverages, those formulas are correct.

But in the MCQ, sometimes they give different variables rather than EBIT, EPS, or change in sales.

So you can think about the concept like M.O.D said:

DOL = degree of fixed costs over variable costs (FC/VC)

DFL = degree of debt over equity (Debt/Equity)

WACC (Weighted Average Cost of Capital) is (Cost of Equity x % equity in capital structure) + (Weighted average cost of debt x % debt in capital structure).

Weighted average cost of debt is synonymous with weighted average interest rate AFTER tax, Yield to maturity rate after tax, market rate after tax, or effective interest rate after tax. (same thing but could show up as different terms)

Cost of debt is not the same as risk free rate.

CAPM is one method they could ask for to find the cost of RE, and yeah you use it to find the cost of equity (don't forget to multiply it with the % of equity in structure also if you are finding WACC).

I'm not sure which MCQ you are referring to, but if you have the question #, I could try to help you out.

Hope that helps.

[MattCPA18]

B3 optional practice question 35,36 & 37 for leverages

And also the reason I was thinking cost of debt and risk free rate were same is because of question 46 also in optional practice questions. Its asking for the after tax cost of debt and the answer showed it adding the 150 basis points to the risk free rate then subtracting the tax. That's why I assumed the pre tax cost of debt was the same as risk free rate. If you could explain that too I would appreciate it.

and thanks M.O.D!!

[MattCPA18]

B3 optional practice question 35,36 & 37 for leverages

And also the reason I was thinking cost of debt and risk free rate were same is because of question 46 also in optional practice questions. Its asking for the after tax cost of debt and the answer showed it adding the 150 basis points to the risk free rate then subtracting the tax. That's why I assumed the pre tax cost of debt was the same as risk free rate. If you could explain that too I would appreciate it.

and thanks M.O.D!!

[Anonymous]

Oh, I see. Yeah for 35-37 it was weird. But I don't think you have to worry about this too much since they give you the complex formulas and you can just plug in the #s.

But generally, I think understanding what M.O.D explained and knowing the formulas from the textbook should be good enough.

For 46, It says “Martin Corp issues debt @ 150 basis points over US Treasury bonds”, so that is why they added to the risk free rate.

I think a logical way of thinking about it is that cost of debt usually would be higher than the risk free rate.

Debt like bonds have more risk than US treasury bills, so bondholders will want a higher return for buying the bonds (higher cost for the company). Otherwise they would just invest in risk free securities like T-bills.

In this question, they basically say they want 150 basis points (1.5%) more return over the risk free rate (7.5%) = 8.5% total. (Then you calculate after tax as well for the cost of debt).

[Author]

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