Understanding Operating and Financial Leverage in Business Valuation

Operating Leverage

The degree of operating leverage measures how sensitive a firm is to its fixed costs. It increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicality on beta. That is, a firm with a given sales cyclicality will increase its beta if fixed costs replace variable costs in its production process.

Financial Leverage and Beta

Financial leverage is the sensitivity to a firm's fixed costs of financing.

The equity beta will always be greater than the asset beta with financial leverage: the equity beta of a levered firm will always be greater than the equity beta of an otherwise identical all-equity firm.

Extensions of the Basic Model

The Firm vs. the Project

Any project's cost of capital depends on the use to which the capital is being put, not the source. Therefore, it depends on the risk of the project and not on the risk of the company.

A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.

If the project's beta differs from that of the firm, the discount rate should be based on the project's beta. We can generally estimate the project's beta by determining the average beta of the project's industry. Sometimes we cannot use the average beta of the project's industry as an estimate of the beta of the project. For example, a new project may not fall neatly into any existing industry. In this case, we can estimate the project's beta by considering the project's cyclicality of revenues and its operating leverage. This approach is qualitative.

Flotation Costs

Flotation costs represent the expenses incurred upon the issue, or float, of new bonds or stocks. These are incremental cash flows of the project, which typically reduce the NPV since they increase the initial project cost.

The Weighted Average Cost of Capital

Because interest expense is tax-deductible, we multiply the last term by (1–Tc). An all-equity firm's average cost of capital is equal to its cost of equity. In terms of firm's valuation, the value of the firm is the present value of expected future (distributable) cash flow discounted at the WACC. To find equity value, subtract the value of the debt from the firm's value.