5

Operating and
Financial Leverage

Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All

 Chapter Outline
• What is leverage?
• Operating leverage.
• Financial leverage.
• Potential profits or increased risk?

5-2
 What is Leverage?
• Use of special forces and effects to magnify
or produce more than the normal results
from a given course of action.
– Can produce beneficial results in favorable
conditions.
– Can produce highly negative results in
unfavorable conditions.

5-3
 Leverage in Business
• Determining type of fixed operational costs.
– Plant and equipment
• Eliminates labor in production of inventory.
– Expensive labor
• Lessens opportunity for profit but reduces risk
exposure.
• Determining type of fixed financial costs.
– Debt financing
• Substantial profits but failure to meet contractual
obligations can result in bankruptcy.
– Selling equity
• Reduces potential profits but minimize risk exposure.
5-4
 Operating Leverage
• The extent to which fixed assets and
associated fixed costs are utilized in a
business.
• Operational costs include:
– Fixed
– Variable
– Semivariable

5-5
Break-Even Chart: Leveraged Firm

5-6
 Break-Even Analysis
• The break-even point is at 50,000 units,
where the total costs and total revenue lines
intersect.
Units = 50,000 .

Total Variable Fixed Costs Total Costs Total Revenue Operating Income

Costs (TVC) (FC) (TC) (TR) (loss)

(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0

5-7
 Break-Even Analysis (cont’d)
• The break-even point can also be calculated
by:

Fixed costs = Fixed costs = FC

Contribution margin Price – Variable cost per unit P – VC

i.e. $60,000 = $60,000 = 50,000 units

$2.00 - $0.80 $1.20

5-8
Volume-Cost-Profit Analysis:
Leveraged Firm

5-9
 A Conservative Approach
• Some firms choose not to operate at high
degrees of operating leverage.
– More expensive variable costs may be
substituted for automated plant and equipment.
– This approach may cut into potential profitability
of the firm as shown in Figure 5-2.

5-10
Break-Even Chart: Conservative
Firm

5-11
Volume-Cost-Profit Analysis:
Conservative Firm

5-12
 The Risk Factor
• Factors influencing decision on maintaining
a conservative or a leveraged stance
include:
– Economic condition.
– Competitive position within industry.
– Future position – stability versus market
leadership.
– Matching an acceptable return with a desired
level of risk.

5-13
 Cash Break-Even Analysis
• Helps in analyzing the short-term outlook of
a firm.
• Non-cash items are excluded:
– Depreciation
– Sales (accounts receivable rather than cash)
– Purchase of materials
– Accounts payable

5-14
 Degree of Operating Leverage
(DOL)
• Percentage change in operating income
– Occurs as a result of a percentage change in
units sold.
– Computed only over a profitable range of
operations.
– Directly proportional to the firm’s break-even
point.

DOL = Percent change in operating income

Percent change in unit volume

5-15
Operating Income or Loss

5-16
 Computation of DOL
• Leveraged firm:

DOL = Percent change in operating income = $24,000 X 100

Percent change in unit volume $36,000
20,000 X 100
80,000
= 67% = 2.7
25%
• Conservative firm:

DOL = Percent change in operating income = $8,000 X 100

Percent change in nit volume $20,000
20,000 X 100
80,000
= 40% = 1.6
25%
5-17
 Algebraic Formula for DOL
DOL = Q (P – VC)
Q (P – VC) – FC
Where,
• Q = Quantity at which DOL is computed.
• P = Price per unit.
• VC = Variable costs per unit.
• FC = Fixed costs.
• For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80,
and FC = $60,000:

DOL = 80,000 ($2.00 - $0.80) ;

80,000 ($2.00 - $0.80) - $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) - $60,000 $96,000 - $60,000
i.e. DOL = 2.7
5-18
 Limitations of Analysis
• Weakening of price in an attempt to capture
an increasing market.
• Cost overruns when moving beyond an
optimum-size operation.
• Relationships are not fixed.

5-19
Nonlinear Break-Even Analysis

5-20
 Financial Leverage
• Reflects the amount of debt used in the
capital structure of the firm.
– Determines how the operation is to be financed.
– Determines the performance between two firms
having equal operating capabilities.

BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

5-21
 Impact on Earnings
• Examine two financial plans for a firm, where
$200,000 is required to carry the assets.

Total Assets = $200,000

Plan A (leveraged) Plan B (conservative)

Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)
Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)

Total financing $200,000 $200,000

5-22
Impact of Financing Plan on
Earnings per Share

5-23
Financing Plans and Earnings per
Share

5-24
 Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT

• For the purpose of computation, it can be restated as:

DFL = EBIT .
EBIT – I
• Plan A (Leveraged):
DFL = EBIT = $36,000 = $36,000 = 1.5
EBIT – I $36,000 - $12,000 $24,000

• Plan B (Conservative):
DFL = EBIT = $36,000 = $36,000 = 1.1
EBIT – I $36,000 - $4,000 $32,000
5-25
 Limitations to the Use of Financial
Leverage
• Beyond a point, debt financing is detrimental
to the firm.
– Lenders will perceive a greater financial risk.
– Common stockholders may drive down the
price.
• Recommended for firms that are:
– In an industry that is generally stable.
– In a positive stage of growth.
– Operating in favorable economic conditions.
5-26
Combining Operating and Financial
Leverage
• Combined leverage: when both leverages
allow a firm to maximize returns.
– Operating leverage:
• Affects the asset structure of the firm.
• Determines the return from operations.
– Financial leverage:
• Affects the debt-equity mix.
• Determines how the benefits received will be
allocated.

5-27
Combined Leverage Influence on the
Income Statement

5-28
Combining Operating and Financial
Leverage

5-29
Operating and Financial
Leverage

5-30
 Degree of Combined Leverage
• Uses the entire income statement.
• Shows the impact of a change in sales or
volume on bottom-line earnings per share.
DCL = Percentage change in EPS ;
Percentage change in sales (or volume)

• Using data from Table 5-7:

Percent change in EPS = $1.50 X 100

Percent change in sales $1.50 = 100% = 4
$40,000 X 100 $25%
$160,000
5-31
 Degree of Combined Leverage
(cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
• Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs
per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) =
$12,000.

DCL = 80,000 ($2.00 - $0.80) =

80,000 ($2.00 - $0.80) - $60,000 - $12,000
= 80,000 ($1.20) =
80,000 ($1.20) - $72,000
DCL = $96,000 = $96,000 = 4
$96,000 - $72,000 $24,000

5-32