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Chapter 15 Analysis and Impact of Leverage

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What is Leverage Company A: sales increases 2.9 percent, but net income increases 16.9 percent. Company B: sales decreases 3.6 percent, but net income decreases 19.4 percent.

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Two concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firms business risk. 2) Financial Leverage - affects a firms financial risk.

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Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM EBIT EPS Stock-holders

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Business Risk Affected by: Sales volume variability Competition Product diversification Operating leverage Growth prospects Size

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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.

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Financial Risk The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders

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Financial Leverage The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

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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.

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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).

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Operating Leverage What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

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Quantity { $ Total Revenue Total Cost FC Break- even point Q1Q1 + - } EBIT

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Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q1Q1 + - EBIT

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With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

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Breakeven point (units of output) Q B = breakeven level of Q. F = total anticipated fixed costs. P = sales price per unit. V = variable cost per unit. Breakeven Calculations Q B = F P - V

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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 -

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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.

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DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales = Degree of Operating Leverage from Sales Level (S)

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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

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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

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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.

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DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT Degree of Financial Leverage =

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DFL = EBIT EBIT - I If we have the data, we can use this formula:

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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

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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.

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DCL = DOL x DFL Degree of Combined Leverage = % change in EPS % change in Sales change in EPS EPS change in Sales Sales =

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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 =

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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

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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?

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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

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EPS Financial leverage Operating Income Sales Operating leverage Levered Company

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Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 1,400,000 - 800,000 350,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT EBIT

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EPS Operating Income Sales Operating leverage 10% 17.14% Levered Company

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Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350,000 350,000 225,000 225,000 = 1.556

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EPS Financial leverage Operating Income Sales 10% 15.56% Levered Company

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Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400,000 - 800,000 1,400,000 - 800,000 225,000 225,000 = 2.667 =

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EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage Levered Company

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Sales (110,000 units)1,540,000 Sales (110,000 units)1,540,000 Variable Costs (880,000) Variable Costs (880,000) Fixed Costs (250,000) Fixed Costs (250,000) EBIT 410,000 ( +17.14%) EBIT 410,000 ( +17.14%) Interest (125,000) Interest (125,000) EBT 285,000 EBT 285,000 Taxes (34%) (96,900) Taxes (34%) (96,900) Net Income 188,100 Net Income 188,100 EPS $1.881 ( +26.67%) EPS $1.881 ( +26.67%) Levered Company 10% increase in sales