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07 Leverages

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    Leverage

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    Break Even Analysis

    Relationship between Cost, Volume & Profit

    At Break Even, EBIT = Zero; GP = FC

    Review:

    Sales/ Revenues_ COGS/ COS/ Direct Cost/ Variable Cost

    = Operating Profit/ Gross Profit/ Contribution to

    Overhead

    _ Operating Expense/ Indirect Cost/ Overhead/ FixedCost

    = Operating Income/ EBIT

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    Break Even Example

    Ranbaxy Laboratory sells Ax, an asthma tablet forRs20/unit to distributors; cost is Re1/unit. Fixedcosts (R& D, Marketing) of the manufacturingdivision are Rs200 million/year.

    How many tablets it needs to sell per year to break even?

    Per unit contribution: Selling Price Rs20

    Materials (Re1)

    Gross Profit Rs19

    Overhead: Rs200,000,000

    Break Even Point Rs200 mn / Rs19

    = 10.5 mn tablets

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    Funskool has licensed games from independent

    designers for a 50% royalty on sale price, spends

    Rs50/unit on flashy packaging, and sells the gamesfor Rs200/each. It spends Rs15,000,000 per title on

    advertising. How many copies it needs to sell to

    break even?

    Per unit contribution: Selling Price Rs200

    Cost of Sales (Rs150)

    Gross Profit Rs50

    Overhead: Rs15,000,000

    Break Even Point Rs15mn / Rs50 = .3 million

    copies

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    Comparing Business Models:

    Unit Sales: 5 mn 25 mn 50 mnRanbaxy Laboratory

    Sales Rs100 mn Rs500 mn Rs1 billion

    EBIT (Rs105 mn) Rs275 mn Rs750 mnMargin (105%) 55% 75%

    Funskool

    Sales Rs100 mn Rs500 mn Rs1 billionEBIT Rs10 mn Rs110 mn Rs235 mn

    Margin 10% 22% 23.5%

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    Comparing Breakeven PointsVariable as

    % Total Cost

    Fixed as %

    Total Cost

    Breakeven

    Point

    Operating

    Leverage

    Between Industries

    LAW FIRM High Low Low Low

    RanbaxyLaboratory

    Low High High High

    Within Industries

    VINEYARD Low High High High

    BOTTLER High Low Low Low

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    CERTAIN RELATIONSHIPS

    PBIT = Q(PV) F

    PAT = (PBIT I) ( 1 T)

    EPS = (PBIT

    I) (1

    T)

    Dp

    N

    = [Q(P

    V)

    F

    I] (1

    T)

    Dp

    N

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    OPERATING LEVERAGE

    The sensitivity of profit before interest and taxes

    (PBIT) to changes in unit sales is referred to as the

    degree of operating leverage (DOL).

    DOL =

    PBIT/PBIT

    Q / Q

    =Q(P

    V)

    =Contribution

    Q(PV) F Profit before interest and

    tax

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    Quantifying Operating Leverage

    % Change in EBIT divided by % Change in Sales= Operating Leverage Ratio

    Example: Scenario 1 Scenario 2 % changeSales Rs1,000,000 Rs1,100,000 10%

    COGS (20% sales) (Rs200,000) (Rs220,000) 10%

    Gross Profit Rs800,000 Rs880,000

    Operating Expense (Rs500,000) (Rs500,000) Fixed

    EBIT Rs300,000 Rs380,000 27%

    Operating Leverage = 2.7 x

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    Financial Leverage

    Financial Leverage= amount of DEBT in Capital

    Structure

    Debt used to

    Limit Shareholder Dilution

    Reduce Cost of Capital Increase Shareholder returns

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    EPS UNDER ALTERNATIVE FINANCING PLANS

    Equity Financing Debt FinancingEBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 EBIT : 4,000,000

    Interest - - 1,400,000 1,400,000

    Profit before taxes 2,000,000 4,000,000 600,000 2,600,000

    Taxes 1,000,000 2,000,000 300,000 1,300,000Profit after tax 1,000,000 2,000,000 300,000 1,300,000

    Number of equity

    shares 2,000,000 2,000,000 1,000,000 1,000,000

    Earnings per share 0.50 1.00 0.30 1.30

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    BREAK-EVEN EBIT LEVEL

    The EBIT indifference point between two alternative

    financing plans can be obtained by solving the following

    equation for EBIT*

    (EBIT *I1) (1t) (EBIT*I2) (1t)

    =

    n1 n2

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    ROIROE ANALYSIS

    ROE = [ROI + (ROIr) D/E] (1t)

    where ROE = return on equity

    ROI = return on investment

    r = cost of debt

    D/E = debt-equity ratio

    t = tax rate

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    Measuring Financial

    Leverage

    Financial Leverage = % Net Income% EBIT

    When EBIT goes up or down, how

    much does it affect Net Income?

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    FINANCIAL LEVERAGE

    The sensitivity of profit before tax (or profit after tax or earnings per

    share) to changes in PBIT is referred to as the degree of financial

    leverage.

    DFL =

    PBT / PBT PBIT

    =

    PBIT / PBIT PBIT I

    =

    Profit before interest and tax

    Profit before tax

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    Financial Leverage ExerciseExample: Scenario 1 Scenario 2 % change

    EBIT Rs2,000,000 Rs2,400,000 20%

    Interest Expense (Rs200,000) (Rs200,000) fixed

    Pretax Income Rs1,800,000 Rs2,200,000 22%

    Taxes @40% (Rs720,000) (Rs880,000)

    Net Income Rs1,080,000 Rs1,320,000 22%

    Financing Leverage = 1.1x

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    Effects of Financial Leverage

    When an investor combines equity funds

    with borrowed funds to leverage an

    investment, the leverage increases

    Expected return to the equity investor

    Risk of the investment to the equity

    investor

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    Measuring Total Leverage

    Operating Leverage = % EBIT

    % Sales

    Financial Leverage = % Net Income

    % EBIT

    Total Leverage = % Net Income

    % Sales

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    Background

    We know WHAT financial securities are

    We know HOW to determine their cost

    We know WHEN to make investments

    We know HOW MUCH finance the firmneeds

    We have to determine Financing Mix

    How much Debt, Equity

    When to choose which financing sources

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    Break Even Analysis

    Relationship between Cost, Volume & Profit

    At Break Even, EBIT = Zero; GP = FC

    Review:

    Sales/ Revenues_ COGS/ COS/ Direct Cost/ Variable Cost

    = Operating Profit/ Gross Profit/ Contribution to

    Overhead

    _ Operating Expense/ Indirect Cost/ Overhead/ FixedCost

    = Operating Income/ EBIT

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    Breakeven Analysis

    Year 1 Year 2 Year 3 Year 4

    Sales

    COGS

    Gross ProfitRs

    high

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    Breakeven Analysis

    Year 1 Year 2 Year 3 Year 4

    Sales

    EBIT

    Fixed Costs

    Break Even Point

    Gross Profit

    hi

    Rs

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    Break Even Example

    Ranbaxy Laboratory sells Ax, an asthma tablet forRs20/unit to distributors; cost is Re1/unit. Fixedcosts (R& D, Marketing) of the manufacturingdivision are Rs200 million/year.

    How many tablets it needs to sell per year to break even?

    Per unit contribution: Selling Price Rs20

    Materials (Re1)

    Gross Profit Rs19

    Overhead: Rs200,000,000

    Break Even Point Rs200 mn / Rs19

    = 10.5 mn tablets

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    Funskool has licensed games from independent

    designers for a 50% royalty on sale price, spends

    Rs50/unit on flashy packaging, and sells thegames for Rs200/each. It spends Rs15,000,000

    per title on advertising. How many copies it

    needs to sell to break even?

    Per unit contribution: Selling Price Rs200

    Cost of Sales (Rs150)

    Gross Profit Rs50

    Overhead: Rs15,000,000

    Break Even Point Rs15mn / Rs50 = .3 million

    copies

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    Comparing Business Models:

    Unit Sales: 5 mn 25 mn 50 mn

    Ranbaxy Laboratory

    Sales Rs100 mn Rs500 mn Rs1 billion

    EBIT (Rs105 mn) Rs275 mn Rs750 mn

    Margin (105%) 55% 75%

    Funskool

    Sales Rs100 mn Rs500 mn Rs1 billion

    EBIT Rs10 mn Rs110 mn Rs235 mn

    Margin 10% 22% 23.5%

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    What does Break Even tell us?

    Most costs as variable costs, typically haveLow Contribution Margin per unit (e.g., lawfirm)

    Most costs as fixed costs, typically have HighContribution Margin per unit (e.g., RanbaxyLaboratory)

    Compare business strategies:

    Law Firm vs Ranbaxy Laboratory

    Vineyard vs Bottler Quantify with Operating Leverage: change

    in Sales vs change in Profits

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    Comparing Breakeven PointsVariable as

    % Total Cost

    Fixed as %

    Total Cost

    Breakeven

    Point

    Operating

    Leverage

    Between Industries

    LAW FIRM High Low Low Low

    RanbaxyLaboratory

    Low High High High

    Within Industries

    VINEYARD Low High High High

    BOTTLER High Low Low Low

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    Quantifying Operating Leverage

    % Change in EBIT divided by % Change in Sales= Operating Leverage Ratio

    Example: Scenario 1 Scenario 2 % change

    Sales Rs1,000,000 Rs1,100,000 10%

    COGS (20% sales) (Rs200,000) (Rs220,000) 10%

    Gross Profit Rs800,000 Rs880,000

    Operating Expense

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