Why is the Net Income or EPS taken to account for the Financial Leverage? Shouldn’t it be EBT (Earnings after interest but before taxes)? Otherwise taxes would be magnifying our financial leverage!
I assume we’re talking about DFL. Taxes – assuming that they’re proportional to EBT – do not affect DFL.
For example:
- EBIT = 100
- Interest = 10
- Tax rate = 30%
Then,
- EBT = 100 – 10 = 90
- Taxes = 30% × 90 = 27
- Net income = 90 – 27 = 63
If EBIT changed to 110, then,
- EBT = 110 – 10 = 100
- Taxes = 30% × 100 = 30
- Net income = 100 – 30 = 70
and,
DFL = %ΔNI / %ΔEBIT
= [(70 – 63)/63] / [(110 – 100)/100]
= 1.11
Suppose, instead, that the tax rate were 40%. Then,
- EBIT = 100
- Interest = 10
- EBT = 100 – 10 = 90
- Taxes = 40% × 90 = 36
- Net income = 90 – 36 = 54
If EBIT changed to 110, then
- EBT = 110 – 10 = 100
- Taxes = 40% × 100 = 40
- Net income = 100 – 340 = 60
and,
DFL = %ΔNI / %ΔEBIT
= [(60 – 54)/54] / [(110 – 100)/100]
= 1.11
Great!
By the way, if the tax rate is constant, %ΔNI / %ΔEBT = 1.
Got it