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Operating and
Financial Leverage
16-1
16-2
Operating and
Financial Leverage
Operating Leverage
Financial Leverage
Total Leverage
Combination of Methods
16-3
Meaning of leverage
In general ,leverage refers to accomplish certain things which
are otherwise not possible i.e. lifting of heavy objects with the
help of lever. This concept of leverage is valid in business also .
In finance ,the term leverage is used to describe the firms
ability to use fixed cost assets or funds to increase the return to
its owners; i.e. equity shareholders. In other words, the fixed
cost funds i.e. debentures & preference share capital act as the
fulcrum , which assist the lever i.e. the firm to lift i.e. to increase
the earnings of its owner i.e. the equity shareholders.
If earnings less the variable costs exceed the fixed costs i.e.
preference dividend & interest on debenture, or earnings before
interest and taxes exceed the fixed return requirement, the
leverage is called favorable . when they do not ,the result is
unfavorable leverage .
16-4
DIAGRAM
16-5
Leverage in physics
Leverage in finance
Operating Leverage
Operating Leverage -- The use of
fixed operating costs by the firm.
16-6
Impact of Operating
Leverage on Profits
(in thousands)
Firm F
$10
Sales
Operating Costs
Fixed
7
Variable
2
Operating Profit $ 1
FC/total costs
FC/sales
16-7
.78
.70
Firm V Firm 2F
$11
$19.5
2
7
$ 2
14
3
$ 2.5
.22
.18
.82
.72
Impact of Operating
Leverage on Profits
16-8
[ ] Firm V;
V
[ ] Firm 2F.
2F
Impact of Operating
Leverage on Profits
(in thousands)
Firm F
$15
Sales
Operating Costs
Fixed
7
Variable
3
Operating Profit $ 5
Percentage
Change in EBIT*
EBIT 400%
16-9
Firm V Firm 2F
$16.5
$29.25
2
10.5
$ 4
100%
14
4.5
$10.75
330%
Impact of Operating
Leverage on Profits
16-10
Break-Even Analysis
Break-Even Analysis -- A technique for
studying the relationship among fixed
costs, variable costs, sales volume,
and profits.
profits Also called
cost/volume/profit (C/V/P) analysis.
16-11
Break-Even Chart
REVENUES AND COSTS
($ thousands)
Total Revenues
Profits
250
Total Costs
175
Fixed Costs
100
Losses
50
0
16-12
Variable Costs
Break-Even
(Quantity) Point
Break-Even Point -- The sales volume required
so that total revenues and total costs are
equal; may be in units or in sales dollars.
Break-Even
(Quantity) Point
Breakeven occurs when EBIT = 0
Q (P - V) - FC
= EBIT
QBE (P - V) - FC = 0
16-14
QBE (P - V)
= FC
QBE
= FC / (P - V)
a.k.a. Unit Contribution Margin
SBE = FC + (VCBE)
SBE = FC + (QBE )(V)
or
SBE *
= FC / [1 - (VC / S) ]
* Refer to text for derivation of the formula
16-15
Break-Even
Point Example
Basket Wonders (BW) wants to
determine both the quantity and sales
break-even points when:
16-16
Break-Even Chart
REVENUES AND COSTS
($ thousands)
Total Revenues
Profits
250
Total Costs
175
Fixed Costs
100
Losses
50
0
16-18
Variable Costs
Degree of Operating
Leverage (DOL)
Degree of Operating Leverage -- The
percentage change in a firms operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
DOL at Q
units of
=
output
(or sales)
16-19
Percentage change in
operating profit (EBIT)
Percentage change in
output (or sales)
=
=
16-20
Q (P - V )
Q (P - V) - FC
Q
Q - QBE
16-21
S - VC
S - VC - FC
EBIT + FC
EBIT
Break-Even
Point Example
Lisa Miller wants to determine the degree
of operating leverage at sales levels of
6,000 and 8,000 units.
units As we did earlier,
we will assume that:
16-22
6,000
=
6,000 - 4,000
DOL8,000 units =
8,000
=
8,000 - 4,000
16-23
8,000
=
8,000 - 4,000
DEGREE OF OPERATING
LEVERAGE (DOL)
2,000
4,000
6,000
QBE
QUANTITY PRODUCED AND SOLD
16-25
8,000
16-26
16-27
DOL$10,000 sales
16-28
1,000 + 7,000
=
1,000
8.0
DOL$11,000 sales
16-29
2,000 + 2,000
=
2,000
2.0
DOL$19,500 sales
16-30
2,500 + 14,000
=
=
2,500
6.6
Financial Leverage
Financial Leverage -- The use of
fixed financing costs by the firm.
The British expression is gearing.
16-32
EBIT-EPS Break-Even,
or Indifference, Analysis
EBIT-EPS Break-Even Analysis -- Analysis
of the effect of financing alternatives on
earnings per share. The break-even point is
the EBIT level where EPS is the same for
two (or more) alternatives.
Calculate EPS for a given level of EBIT at a
given financing structure.
EPS
16-33
EBIT-EPS Chart
Basket Wonders has $2 million in LT financing
(100% common stock equity).
16-34
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-36
6
5
Common
4
3
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-38
Debt
6
5
Indifference point
between debt and
common stock
financing
4
3
Common
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-40
Debt
Preferred
Common
4
3
Indifference point
between preferred
stock and common
stock financing
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
6
Lower risk.
risk Only a small
probability that EPS will
be less if the debt
alternative is chosen.
5
4
Common
3
2
1
0
100
200
300
400
500
600
EBIT ($ thousands)
700
Probability of Occurrence
16-41
Debt
(for the probability distribution)
Higher risk.
risk A much larger
probability that EPS will
be less if the debt
alternative is chosen.
5
4
Common
3
2
1
0
100
200
300
400
500
600
EBIT ($ thousands)
700
Probability of Occurrence
16-42
Debt
Degree of Financial
Leverage (DFL)
Degree of Financial Leverage -- The
percentage change in a firms earnings
per share (EPS) resulting from a 1
percent change in operating profit.
16-43
Percentage change in
DFL at
earnings per share (EPS)
EBIT of
X dollars = Percentage change in
operating profit (EBIT)
EBIT
EBIT - I - [ PD / (1 - t) ]
DFL $500,000
=
=
16-45
$500,000
$500,000 - 0 - [0 / (1 - 0)]
1.00
DFL $500,000
16-46
$500,000
{ $500,000 - 100,000
- [0 / (1 - 0)] }
$500,000 / $400,000
1.25
DFL $500,000
16-47
$500,000
=
{ $500,000 - 0
- [90,000 / (1 - .30)]
.30 }
=
$500,000 / $400,000
1.35
Variability of EPS
DFLEquity
Which financing
method will have
DFLDebt
= 1.25
the greatest relative
variability in EPS?
DFLPreferred = 1.35
Preferred stock financing will lead to
the greatest variability in earnings per
share based on the DFL.
16-48
= 1.00
Financial Risk
Financial Risk -- The added variability in
earnings per share (EPS) -- plus the risk of
possible insolvency -- that is induced by the
use of financial leverage.
16-49
16-50
Degree of Total
Leverage (DTL)
Degree of Total Leverage -- The
percentage change in a firms earnings
per share (EPS) resulting from a 1
percent change in output (sales).
Percentage change in
DTL at Q units
(or S dollars) earnings per share (EPS)
of output (or = Percentage change in
sales)
output (or sales)
16-51
DTL Q units
16-52
EBIT + FC
EBIT - I - [ PD / (1 - t) ]
Q (P - V )
=
Q (P - V) - FC - I - [ PD / (1 - t) ]
DTL Example
Lisa Miller wants to determine the
Degree of Total Leverage at
EBIT=$500,000. As we did earlier, we
will assume that:
Fixed
16-53
Baskets
Variable
of sales
=
16-54
$500,000 + $100,000
$500,000 - 0 - [ 0 / (1 - .3)
.3 ]
1.20
*Note: No financial leverage.
of sales
=
16-55
$500,000 + $100,000
{ $500,000 - $100,000
- [ 0 / (1 - .3)
.3 ] }
1.50
*Note: Calculated on Slide 16-44.
E(EPS)
$3.50
$5.60
DTL
1.20
1.50
What is an Appropriate
Amount of Financial Leverage?
Debt Capacity -- The maximum amount of debt
(and other fixed-charge financing) that a firm
can adequately service.
16-57