115 CFA
File: Corporate Finance - Reading 34 - 2. Financial Risk and Financial Leverage

2. Financial Risk and Financial Leverage

a. define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk;

b. calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage;

c. analyze the effect of financial leverage on a company's net income and return on equity;

From a stockholder perspective, what is financial risk?
Financial risk is the additional risk placed on the common stockholders as a result of the decision to use fixed-income securities (debt and preferred stock).

What two factors does financial risk depend on?
1. Cash flow volatility. The more volatile (stable) a firm's cash flows, the higher (lower) the financial risk.
2. Financial leverage. The higher the financial leverage, the higher the financial risk.

What is Degree of Total Leverage (DTL)?
The degree of total leverage (DTL) combines degree of operating leverage (DOL) and degree of financial leverage (DFL), and measures the impact of a given percentage change in sales on EPS.

What is the breakeven point?
The breakeven point is the volume of sales at which total costs equal total revenues, causing net income to equal zero: PQ - VQ - F - I = 0

What is the operating breakeven point?
The operating breakeven point is the number of outputs at which revenues = operating costs.

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