Operating LeverageOperating Leverage Financial LeverageFinancial Leverage

2005, Pearson Prentice Hall

Chapter 15 – Analysis and Chapter 15 – Analysis and Impact of LeverageImpact of Leverage

What is Leverage?What is Leverage?

What is Leverage?What is Leverage?

Two concepts that enhance Two concepts that enhance our understanding of risk...our understanding of risk...

1) 1) Operating LeverageOperating Leverage - affects a - affects a firm’s firm’s business riskbusiness risk..

2) 2) Financial LeverageFinancial Leverage - affects a - affects a firm’s firm’s financial riskfinancial risk..

Business RiskBusiness Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s firm’s operating income (EBIT).operating income (EBIT).

Business RiskBusiness Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Business RiskBusiness Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Business RiskBusiness Risk

Affected by:Affected by: Sales volume variabilitySales volume variability CompetitionCompetition Product diversificationProduct diversification Operating leverageOperating leverage Growth prospectsGrowth prospects SizeSize

Operating LeverageOperating Leverage

The use of The use of fixed operating costsfixed operating costs as as opposed to opposed to variable operating variable operating costscosts..

A firm with relatively high fixed A firm with relatively high fixed operating costs will experience operating costs will experience more variable operating incomemore variable operating income if if sales change.sales change.

EBIT

OperatingLeverage

Financial RiskFinancial Risk

The The variability or uncertainty of variability or uncertainty of a firm’s earnings per sharea firm’s earnings per share (EPS)(EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..

Financial RiskFinancial Risk

The variability or uncertainty of The variability or uncertainty of a firm’s earnings per share (EPS) a firm’s earnings per share (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses financial leverage.firm uses financial leverage.

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Financial RiskFinancial Risk

The variability or uncertainty of The variability or uncertainty of a firm’s earnings per share (EPS) a firm’s earnings per share (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Financial LeverageFinancial Leverage

The use of The use of fixed-costfixed-cost sources of sources of financingfinancing (debt, preferred stock) (debt, preferred stock) rather than rather than variable-costvariable-cost sources sources (common stock).(common stock).

EPS

FinancialLeverage

Breakeven AnalysisBreakeven Analysis

Illustrates the effects of Illustrates the effects of operating operating leverage.leverage.

Useful for forecasting the Useful for forecasting the profitability of a firm, division, or profitability of a firm, division, or product line.product line.

Useful for analyzing the impact of Useful for analyzing the impact of changes in fixed costs, variable changes in fixed costs, variable costs, and sales price.costs, and sales price.

Quantity

$

Breakeven Analysis

Quantity

$

Total Revenue

CostsCosts

Suppose the firm has both Suppose the firm has both fixed fixed operating costsoperating costs (administrative (administrative salaries, insurance, rent, property salaries, insurance, rent, property tax) and tax) and variable operating costsvariable operating costs (materials, labor, energy, (materials, labor, energy, packaging, sales commissions).packaging, sales commissions).

Quantity

$

Total Revenue

Quantity

{

$

Total Revenue

Total Cost

FC

Quantity

{

$

Total Revenue

Total Cost

FC

Q1

+

-

} EBIT

Quantity

{

$

Total Revenue

Total Cost

FC

Break-evenpoint

Q1

+

-

} EBIT

Operating LeverageOperating Leverage

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

Quantity

{

$

Total Revenue

Total Cost

FC

Break-evenpoint

Q1

+

-

} EBIT

Quantity

{

$

Total Revenue

Total Cost= FixedFC

Break-evenpoint

}

Q1

+

-

EBIT

With high With high operating leverageoperating leverage, , an increase in an increase in salessales

produces a relatively larger produces a relatively larger increase in increase in operating operating

incomeincome..

Quantity

{

$

Total Revenue

Total Cost= FixedFC

Break-evenpoint

}

Q1

+

-

EBIT

Quantity

{

$

Total Revenue

Total Cost= FixedFC

Break-evenpoint

}

Q1

+

-

EBIT

Trade-off: Trade-off: the firm hasthe firm has

a higher breakeven a higher breakeven point. If sales are not point. If sales are not high enough, the firm high enough, the firm will not meet its fixedwill not meet its fixed

expenses!expenses!

Breakeven point (units of output)Breakeven point (units of output)

QQB = B = breakeven level of Q.breakeven level of Q. F = total anticipated fixed costs.F = total anticipated fixed costs. P = sales price per unit.P = sales price per unit. V = variable cost per unit.V = variable cost per unit.

Breakeven CalculationsBreakeven Calculations

QB = FP - V

Breakeven point (sales dollars)Breakeven point (sales dollars)

S* = breakeven level of sales.S* = breakeven level of sales. F = total anticipated fixed costs.F = total anticipated fixed costs. S = total sales.S = total sales. VC = total variable costs.VC = total variable costs.

Breakeven CalculationsBreakeven Calculations

S* = F VC S

1 -

Analytical Income StatementAnalytical Income Statement

salessales

- variable costs- variable costs

-- fixed costs fixed costs

operating incomeoperating income

-- interest interest

EBTEBT

-- taxes taxes

net incomenet income

Degree of Operating Degree of Operating Leverage (DOL)Leverage (DOL)

Operating leverageOperating leverage:: by using fixed by using fixed operating costs, a small change in operating costs, a small change in sales revenuesales revenue is magnified into a is magnified into a larger change in larger change in operating incomeoperating income..

This “multiplier effect” is called This “multiplier effect” is called the the degree of operating leveragedegree of operating leverage..

DOLs = % change in EBIT% change in sales

change in EBIT EBITchange in sales sales

=

Degree of Operating LeverageDegree of Operating Leveragefrom Sales Level (S)from Sales Level (S)

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Operating LeverageDegree of Operating Leveragefrom Sales Level (S)from Sales Level (S)

Q(P - V) Q(P - V) - F

=

DOLs = Sales - Variable Costs EBIT

What does this tell us?What does this tell us?

If If DOL = 2,DOL = 2, then a then a 1%1% increase in increase in sales will result in a sales will result in a 2%2% increase in increase in operating income (EBIT).operating income (EBIT).

Stock-holdersEBIT EPSSales

What does this tell us?What does this tell us?

If If DOL = 2,DOL = 2, then a then a 1%1% increase in increase in sales will result in a sales will result in a 2%2% increase in increase in operating income (EBIT).operating income (EBIT).

Stock-holdersEBIT EPSSales

Degree of Financial Degree of Financial Leverage (DFL)Leverage (DFL)

Financial leverageFinancial leverage: by using fixed : by using fixed cost financing, a small change in cost financing, a small change in operating incomeoperating income is magnified into is magnified into a larger change in a larger change in earnings per earnings per shareshare..

This “multiplier effect” is called This “multiplier effect” is called the the degree of financial leveragedegree of financial leverage..

DFL = % change in EPS% change in EBIT

change in EPS EPSchange in EBIT EBIT

Degree of Financial Leverage Degree of Financial Leverage

=

Degree of Financial Leverage Degree of Financial Leverage

DFL = EBIT EBIT - I

If we have the data, we can use this If we have the data, we can use this formula:formula:

What does this tell us?What does this tell us?

If If DFL = 3DFL = 3, then a , then a 1%1% increase in increase in operating income will result in a operating income will result in a 3%3% increase in earnings per share.increase in earnings per share.

Stock-holdersEBIT EPSSales

What does this tell us?What does this tell us?

If If DFL = 3DFL = 3, then a , then a 1%1% increase in increase in operating income will result in a operating income will result in a 3%3% increase in earnings per share.increase in earnings per share.

Stock-holdersEBIT EPSSales

Degree of Combined Degree of Combined Leverage (DCL)Leverage (DCL)

Combined leverageCombined leverage:: by using by using operating operating leverageleverage and and financial leveragefinancial leverage, a small , a small change in change in salessales is magnified into a larger is magnified into a larger change in change in earnings per shareearnings per share..

This “multiplier effect” is called the This “multiplier effect” is called the degree of combined leveragedegree of combined leverage..

DCL = DOL x DFL

Degree of Combined Leverage Degree of Combined Leverage

=% change in EPS% change in Sales

change in EPS EPSchange in Sales Sales

=

Degree of Combined Leverage Degree of Combined Leverage

If we have the data, we can use this If we have the data, we can use this formula:formula:

DCL = Sales - Variable Costs EBIT - I

Q(P - V) Q(P - V) - F - I

=

What does this tell us?What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

What does this tell us?What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

Stock-holdersEBIT EPSSales

What does this tell us?What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

Stock-holdersEBIT EPSSales

In-class Project:In-class Project:

Based on the following information on Based on the following information on Levered Company, answer these Levered Company, answer these questions:questions:

1) If 1) If salessales increase by 10%, what should increase by 10%, what should happen to happen to operating incomeoperating income??

2) If 2) If operating incomeoperating income increases by 10%, increases by 10%, what should happen to what should happen to EPSEPS??

3) If 3) If salessales increase by 10%, what should be increase by 10%, what should be the effect on the effect on EPSEPS??

Levered CompanyLevered Company

Sales (100,000 units)Sales (100,000 units) $1,400,000$1,400,000

Variable CostsVariable Costs $800,000$800,000

Fixed CostsFixed Costs $250,000$250,000

Interest paidInterest paid $125,000$125,000

Tax rateTax rate 34%34%

Common shares outstandingCommon shares outstanding 100,000100,000

EPS

Financialleverage

OperatingIncomeSales

Operatingleverage

Levered CompanyLevered Company

Degree of Operating Leverage Degree of Operating Leverage from Sales Level (S)from Sales Level (S)

1,400,000 - 800,0001,400,000 - 800,000 350,000350,000

= 1.714= 1.714

=

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

EPSOperating

IncomeSales

LeveredLevered CompanyCompany

EPSOperating

IncomeSales

Operatingleverage

Levered CompanyLevered Company

EPSOperating

IncomeSales

Operatingleverage

10%

Levered CompanyLevered Company

EPSOperating

IncomeSales

Operatingleverage

10%17.14%

Levered CompanyLevered Company

Degree of Financial Leverage Degree of Financial Leverage

DFL = DFL = EBIT EBIT EBIT - IEBIT - I

= = 350,000 350,000 225,000225,000

= 1.556= 1.556

EPSOperating

IncomeSales

Levered CompanyLevered Company

EPSOperating

IncomeSales

Financialleverage

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

10%

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

10%15.56%

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

10%15.56%

Levered CompanyLevered Company

Degree of Combined Leverage Degree of Combined Leverage

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

1,400,000 - 800,000 1,400,000 - 800,000 225,000225,000

= 2.667= 2.667

=

EPSOperating

IncomeSales

Levered CompanyLevered Company

EPSOperating

IncomeSales

Operatingleverage

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

Operatingleverage

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

Operatingleverage

10%

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

Operatingleverage

10%26.67%

Levered CompanyLevered Company

EPS

Financialleverage

OperatingIncomeSales

10%26.67%

Operatingleverage

Levered CompanyLevered Company

Sales (110,000 units)Sales (110,000 units) 1,540,0001,540,000

Variable CostsVariable Costs (880,000) (880,000)

Fixed CostsFixed Costs (250,000)(250,000)

EBITEBIT 410,000410,000 ( +17.14%)( +17.14%)

InterestInterest (125,000)(125,000)

EBTEBT 285,000 285,000

Taxes (34%)Taxes (34%) (96,900)(96,900)

Net IncomeNet Income 188,100 188,100

EPSEPS $1.881$1.881 ( +26.67%)( +26.67%)

Levered CompanyLevered Company10% increase in sales10% increase in sales