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MANAGEMENT P-2
LEVERAGE
- results from the use of fixed-cost assets or funds to magnify
returns to the firm’s owners.
- The amount of leverage in the firm’s capital structure can
significantly affect its value by affecting return and risk.
TYPES OF LEVERAGE
Sales revenue
Operating Less: Cost of Goods Sold
Gross profit
Leverage Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest Total
Net profit before taxes
Leverage
Financial Less: Taxes
Net profit after taxes
Leverage Less: Preferred stock dividends
Earnings available for common stockholders
𝐹𝐶
𝑄=
𝑃 − 𝑉𝐶
EXAMPLE
Assume that Minahal Kita Inc., a small poster retailer, has fixed
operating costs of P2,500, its sale price per unit (poster) is
P10, and its variable operating cost per unit is P5. What is the
operating breakeven point?
THE GRAPHICAL APPROACH
It is where the operating breakeven point is the point at which the total
operating cost (fixed cost plus variable operating cost) is equal to the
sales revenue.
GRAPHICAL APPROACH
Assume that Minahal Kita
wishes to evaluate the impact
of several options (1)
increasing fixed operating
costs to P3,000, (2) increasing
the sales price per unit to
P12.5, (3) increasing the
variable operating cost per
unit to P7.50, and (4)
simultaneously implementing all
three of these changes.
SENSITIVITY OF OPERATING BREAKEVEN POINT
TO INCREASES IN KEY BREAKEVEN VARIABLES
Increase in Variable Effect on Operating
Breakeven Point
Fixed operating cost (FC) Increase
Sales price per unit (P) Decrease
Variable operating cost per unit (VC) Increase
OPERATING LEVERAGE
The potential use of fixed operating costs to magnify the
effect of changes in sales on the firm’s earnings before
interest and taxes.
OPERATING
LEVERAGE
In Minahal Kita’s example if:
Case 1: A 50% increase in
sales (from 1,000 to 1,500
units) results in 100% increase
in EBIT (P2,500 to P5,000).
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐷𝑂𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
EXAMPLE
In Minahal Kita’s example if:
+100%
Case 1: A 50% increase in Case 1: = 2.0
sales (from 1,000 to 1,500 +50%
units) results in 100% increase
in EBIT (P2,500 to P5,000).
𝑄 𝑥 (𝑃−𝑉𝐶)
DOL at the base sales level Q =
𝑄 𝑥 𝑃−𝑉𝐶 −𝐹𝐶
DOL AT THE BASE PESO SALES, TR
𝑇𝑅−𝑇𝑉𝐶
DOL at the base peso sales, TR =
𝑇𝑅−𝑇𝑉𝐶−𝐹𝐶
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
𝐷𝐹𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
𝐷𝑇𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
This approach is valid only when the same base level of sales
is used to calculate and compare this values. In other words, the
base level of sales must be held constant if we are to compare
the total leverage associated with different levels of fixed cost.
TOTAL LEVERAGE AT A GIVEN BASE LEVEL OF
SALES, Q
𝑄 𝑥 (𝑃−𝑉𝐶)
DTL at base sales level Q = 1
𝑄 𝑥 𝑃−𝑉𝐶 −𝐹𝐶−1−(𝑃𝐷− )
1−𝑇
RELATIONSHIP OF OPERATING, FINANCIAL &
TOTAL LEVERAGE
Total leverage reflects the combined impact of operating
and financial leverage of the firm.