? Operating Leverage
? Financial Leverage
? 2002,Prentice Hall,Inc,
What is Leverage?
What is Leverage?
What is Leverage?
2 concepts that enhance our
understanding of risk..,
1) Operating Leverage - affects a
firm’s business risk,
2) Financial Leverage - affects a
firm’s financial risk,
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
EBIT
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
FIRM EBIT
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
FIRM EBIT EPS
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
FIRM EBIT EPS Stock- holders
Business Risk
? The variability or uncertainty of a
firm’s operating income (EBIT),
FIRM EBIT EPS Stock- holders
Business Risk
Affected by,
? Sales volume variability
? Competition
? Cost variability
? Product diversification
? Product demand
? Operating Leverage
Operating Leverage
? The use of fixed operating costs as
opposed to variable operating
costs,
? A firm with relatively high fixed
operating costs will experience
more variable operating income if
sales change,
EBIT
Operating
Leverage
Financial Risk
? The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage,
Financial Risk
? The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage,
FIRM EBIT EPS Stock- holders
Financial Risk
? The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage,
FIRM EBIT EPS Stock- holders
Financial Leverage
? The use of fixed-cost sources of
financing (debt,preferred stock)
rather than variable-cost sources
(common stock),
EPS
Financial
Leverage
Breakeven Analysis
? Illustrates the effects of operating
leverage,
? Useful for forecasting the
profitability of a firm,division or
product line,
? Useful for analyzing the impact of
changes in fixed costs,variable
costs,and sales price,
Quantity
$
Breakeven Analysis
Quantity
$
Total Revenue
Costs
? Suppose the firm has both fixed
operating costs (administrative
salaries,insurance,rent,property
tax) and variable operating costs
(materials,labor,energy,packaging,
sales commissions),
Quantity
$
Total Revenue
Quantity
{
$
Total Revenue
Total Cost
FC
Quantity
{
$
Total Revenue
Total Cost
FC
Q1
+
-
} EBIT
Quantity
{
$
Total Revenue
Total Cost
FC
Break-
even
point
Q1
+
-
} EBIT
Operating Leverage
? What happens if the firm increases
its fixed operating costs and reduces
(or eliminates) its variable costs?
Quantity
{
$
Total Revenue
Total Cost
FC
Break-
even
point
Q1
+
-
} EBIT
Quantity
{
$
Total Revenue
Total Cost
= Fixed FC
Break-
even
point
}
Q1
+
-
EBIT
With high operating leverage,
an increase in sales
produces a relatively larger
increase in operating
income,
Quantity
{
$
Total Revenue
Total Cost
= Fixed FC
Break-
even
point
}
Q1
+
-
EBIT
Quantity
{
$
Total Revenue
Total Cost
= Fixed FC
Break-
even
point
}
Q1
+
-
EBIT
Trade-off,
the firm has
a higher breakeven
point,If sales are not
high enough,the firm
will not meet its fixed
expenses!
Breakeven Calculations
Breakeven Calculations
Breakeven point (units of output)
QB = F P - V
Breakeven point (units of output)
? QB = breakeven level of Q,
? F = total anticipated fixed costs,
? P = sales price per unit,
? V = variable cost per unit,
Breakeven Calculations
QB = F P - V
Breakeven Calculations
S* =
F
VC
S 1 -
Breakeven point (sales dollars)
Breakeven point (sales dollars)
? S* = breakeven level of sales,
? F = total anticipated fixed costs,
? S = total sales,
? VC = total variable costs,
Breakeven Calculations
S* =
F
VC
S 1 -
Analytical Income Statement
sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
net income
sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
net income
} contribution margin
Analytical Income Statement
sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
net income
} contribution margin
Analytical Income Statement
EBT (1 - t) = Net Income,
so,
Net Income / (1 - t) = EBT
Degree of Operating
Leverage (DOL)
? Operating leverage,by using fixed
operating costs,a small change in
sales revenue is magnified into a
larger change in operating income,
? This,multiplier effect” is called
the degree of operating leverage,
DOLs = % change in EBIT % change in sales
Degree of Operating Leverage
from Sales Level (S)
DOLs = % change in EBIT % change in sales
change in EBIT
EBIT
change in sales
sales
=
Degree of Operating Leverage
from Sales Level (S)
? If we have the data,we can use this formula,
Degree of Operating Leverage
from Sales Level (S)
DOLs = Sales - Variable Costs EBIT
? If we have the data,we can use this formula,
Degree of Operating Leverage
from Sales Level (S)
? If we have the data,we can use this formula,
Degree of Operating Leverage
from Sales Level (S)
Q(P - V)
Q(P - V) - F =
DOLs = Sales - Variable Costs EBIT
What does this tell us?
? If DOL = 2,then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT),
What does this tell us?
? If DOL = 2,then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT),
Stock-
holders EBIT EPS Sales
What does this tell us?
? If DOL = 2,then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT),
Stock-
holders EBIT EPS Sales
Degree of Financial
Leverage (DFL)
? Financial leverage,by using fixed
cost financing,a small change in
operating income is magnified into
a larger change in earnings per
share,
? This,multiplier effect” is called
the degree of financial leverage,
DFL = % change in EPS % change in EBIT
Degree of Financial Leverage
DFL = % change in EPS % change in EBIT
change in EPS
EPS
change in EBIT
EBIT
Degree of Financial Leverage
=
Degree of Financial Leverage
? If we have the data,we can use this
formula,
Degree of Financial Leverage
DFL = EBIT EBIT - I
? If we have the data,we can use this
formula,
What does this tell us?
? If DFL = 3,then a 1% increase in
operating income will result in a 3%
increase in earnings per share,
What does this tell us?
? If DFL = 3,then a 1% increase in
operating income will result in a 3%
increase in earnings per share,
Stock-
holders EBIT EPS Sales
What does this tell us?
? If DFL = 3,then a 1% increase in
operating income will result in a 3%
increase in earnings per share,
Stock-
holders EBIT EPS Sales
Degree of Combined
Leverage (DCL)
? Combined leverage,by using operating
leverage and financial leverage,a small
change in sales is magnified into a larger
change in earnings per share,
? This,multiplier effect” is called the
degree of combined leverage,
Degree of Combined Leverage
DCL = DOL x DFL
Degree of Combined Leverage
DCL = DOL x DFL
Degree of Combined Leverage
% change in EPS
% change in Sales =
DCL = DOL x DFL
Degree of Combined Leverage
= % change in EPS % change in Sales
change in EPS
EPS
change in Sales
Sales
=
Degree of Combined Leverage
? If we have the data,we can use this
formula,
DCL = Sales - Variable Costs EBIT - I
? If we have the data,we can use this
formula,
Degree of Combined Leverage
Degree of Combined Leverage
? If we have the data,we can use this
formula,
DCL = Sales - Variable Costs EBIT - I
Q(P - V)
Q(P - V) - F - I =
What does this tell us?
? If DCL = 4,then a 1% increase in
sales will result in a 4% increase in
earnings per share,
What does this tell us?
? If DCL = 4,then a 1% increase in
sales will result in a 4% increase in
earnings per share,
Stock-
holders EBIT EPS Sales
What does this tell us?
? If DCL = 4,then a 1% increase in
sales will result in a 4% increase in
earnings per share,
Stock-
holders EBIT EPS Sales
In-class Project,
? Based on the following information on
Levered Company,answer these
questions,
1) If sales increase by 10%,what should
happen to operating income?
2) If operating income increases by 10%,
what should happen to EPS?
3) If sales increase by 10%,what should be
the effect on EPS?
Levered Company
Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Common shares outstanding 100,000
Sales
EBIT EPS
DOL
DFL
DCL
Leverage
Levered Company
Sales
EBIT EPS
DOL =
DFL
DCL
Degree of Operating Leverage
from Sales Level (S)
DOLs = Sales - Variable Costs EBIT
Degree of Operating Leverage
from Sales Level (S)
1,400,000 - 800,000
350,000
=
DOLs = Sales - Variable Costs EBIT
Degree of Operating Leverage
from Sales Level (S)
1,400,000 - 800,000
350,000
= 1.714
=
DOLs = Sales - Variable Costs EBIT
Levered Company
Sales
EBIT EPS
DOL = 1.714
DFL =
DCL
Degree of Financial Leverage
DFL = EBIT EBIT - I
Degree of Financial Leverage
DFL = EBIT EBIT - I
= 350,000 225,000
Degree of Financial Leverage
DFL = EBIT EBIT - I
= 350,000 225,000
= 1.556
Levered Company
Sales
EBIT EPS
DOL = 1.714
DFL =
1.556
DCL
Degree of Combined Leverage
DCL = Sales - Variable Costs EBIT - I
Degree of Combined Leverage
DCL = Sales - Variable Costs EBIT - I
1,400,000 - 800,000
225,000
=
Degree of Combined Leverage
DCL = Sales - Variable Costs EBIT - I
1,400,000 - 800,000
225,000
= 2.667
=
Levered Company
Sales
EBIT EPS
DOL = 1.714
DFL =
1.556
DCL
= 2.667
Sales (110,000 units) 1,540,000
Variable Costs (880,000)
Fixed Costs (250,000)
EBIT 410,000 ( +17.14%)
Interest (125,000)
EBT 285,000
Taxes (34%) (96,900)
Net Income 188,100
EPS $1.881 ( +26.67%)
Levered Company
10% increase in sales