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39. If we have the data, we can use this formula: DOLs = from Sales Level (S) Sales - Variable Costs EBITDegree of
Operating Leverage
40. If we have the data, we can use this formula: SaDegree of Operating Leverage DOLs = from Sales Level (S) les Variable Costs EBIT Q(p - v) Q(p - v) - FC =
41. If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).What does this tell
us?
42. If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- EBIT holders
Sales EPSWhat does this tell us?
43. This multiplier effect is called the degree of financial leverage. Financial leverage: by using fixed cost financing, a
small change in operating income is magnified into a larger change in earnings per share. Degree of Financial Leverage
(DFL)
44. Degree of Financial Leverage DFL = % change in EPS % change in EBIT
45. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
46. If we have the data, we can use this formula: DFL = EBIT EBIT - IDegree of Financial Leverage
47. 1 DFL in case where there is preferred stock PD T EBIT EBIT I DFL
48. 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?
49. If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- EBIT
holders Sales EPSWhat does this tell us?
50. This multiplier effect is called the degree of combined leverage. Combined leverage: by using operating leverage
and financial leverage, a small change in sales is magnified into a larger change in earnings per share. Degree of
Combined Leverage (DCL)
51. Degree of Combined Leverage DCL = DOL x DFL % change in EPS % change in Sales = change in EPS EPS change
in Sales Sales =
52. If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - IDegree of Combined Leverage
53. If we have the data, we can use tDegree of Combined Leverage his formula: DCL = Sales - Variable Costs EBIT - I
Q(p - v) Q(p - v) - FC - I =
54. 1 DCL where there is preferred stock Sales VariableCost PD T EBIT I DFL
55. If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.What does this tell us?
56. If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- EBIT holders Sales
EPSWhat does this tell us?
57. 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?Team Project:
58. 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
59. Leverage Sales DOL EPS EBIT DFL DCL
60. Levered Company Sales DOL = EPS EBIT DFL DCL
61. Levered Company Sales DOL = 1.714 EPS EBIT DFL = DCL
62. Levered Company Sales DOL = 1.714 EPS EBIT DFL = 1.556 DCL
63. Levered Company Sales DOL = 1.714 DCL = 2.667 EPS EBIT DFL = 1.556
64. Levered Company 10% increase in sales 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%)
65. What is the impact of the proposed restructuring ? Assume that stock price will remain $20 New Debt equity ratio =
1 New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares, leaving 2,00,000 Proposed debt issue
would raise $ 4,000,000, interest rate = 10 % When all equity firm, price per share = $ 20 Shares outstanding =
400,000 Firms market value = $ 8,000,000 CFO is considering a restructuring that would involve issuing debt and
using the proceeds to buy back some of the outstanding equity. The more debt financing a firm uses in its capital
structure, the more financial leverage it employs. Illustration: The effect of financial leverage
66. Illustration (contd) Current Capital Structure: No debt Recession Expected Expansion EBIT $ 5,00,000 $ 1,000,000
$ 1,500,000 Interest 0 0 0 Net Income $ 5,00,000 $ 1,000,000 $ 1,500,000 ROE 6.25 % 12.50 % 18.75 % EPS $ 1.25 $
2.50 $ 3.75 Proposed Capital Structure: Debt = $ 4,000,000 EBIT $ 500,000 $ 1,000,000 $ 1,500,000 Interest 400,000
400,000 400,000 Net Income $ 100,000 $ 600,000 $ 1,100,000 ROE 2.50 % 15.00 % 27.50 % EPS $ 0.50 $ 3.00 $ 5.50
67. Illustration (contd) In no debt case, every $ 400,000 increase in EBIT increases EPS by $ 1 In proposed capital
structure, every $ 400,000 increase in EBIT increases EPS by $ 2 Breakeven point is indifference point. If EBIT is above
this level, leverage is beneficial, otherwise not.