Operating Leverage Financial Leverage

2002, Prentice Hall, Inc.

What is Leverage?

What is Leverage?

What is Leverage?

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

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

EBIT

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

EBIT

FIRM

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

EBIT

FIRM

EPS

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

EBIT

FIRM

EPS

Stockholders

Business Risk
The variability or uncertainty of a firms operating income (EBIT).

EBIT

FIRM

EPS

Stockholders

Business Risk
Affected by: Sales volume variability Competition Cost variability Product diversification Product demand Operating Leverage

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.

EBIT
Operating Leverage

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.

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. EBIT FIRM EPS Stockholders

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. EBIT FIRM EPS Stockholders

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

EPS
Financial Leverage

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.

Breakeven Analysis
$

Quantity

Total Revenue

Quantity

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).

Total Revenue

Quantity

Total Revenue

Total Cost

FC { Quantity

Total Revenue

} EBIT

Total Cost

FC { Q1
Quantity

Total Revenue

} EBIT

Total Cost

FC {
Breakeven point

Q1

Quantity

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

Total Revenue

} EBIT

Total Cost

FC {
Breakeven point

Q1

Quantity

Total Revenue

+
FC

}
Q1

EBIT
Total Cost = Fixed Quantity

Breakeven point

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

Total Revenue

+
FC

}
Q1

EBIT
Total Cost = Fixed Quantity

Breakeven point

Total Revenue Trade-off:

FC

Breakeven point

the firm has a higher breakeven EBIT point. If sales are not + enough, the firm high will not meet its fixed Total Cost expenses! = Fixed

Q1

Quantity

Breakeven Calculations

Breakeven Calculations
Breakeven point (units of output)

QB =

F P-V

Breakeven Calculations
Breakeven point (units of output)

QB =

F P-V

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

Breakeven Calculations
Breakeven point (sales dollars)

S* =

F VC 1S

Breakeven Calculations
Breakeven point (sales dollars)

S* =

F VC 1S

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

Analytical Income Statement

sales variable costs fixed costs operating income interest EBT taxes net income

Analytical Income Statement

sales contribution margin variable costs fixed costs operating income interest EBT taxes net income

Analytical Income Statement

sales contribution margin variable costs fixed costs operating income interest EBT (1 - t) = Net Income, EBT so, taxes Net Income / (1 - t) = EBT net income

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.

Degree of Operating Leverage

from Sales Level (S)

DOLs =

% change in EBIT % change in sales

Degree of Operating Leverage

from Sales Level (S)

DOLs =

% change in EBIT % change in sales change in EBIT EBIT change in sales sales

Degree of Operating Leverage

from Sales Level (S)
If we have the data, we can use this formula:

Degree of Operating Leverage

from Sales Level (S)
If we have the data, we can use this formula:

Sales - Variable Costs DOLs = EBIT

Degree of Operating Leverage

from Sales Level (S)
If we have the data, we can use this formula:

Sales - Variable Costs DOLs = EBIT = Q(P - V) Q(P - V) - F

What does this tell us?

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

What does this tell us?

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

Sales

EBIT

EPS

Stockholders

What does this tell us?

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

Sales

EBIT

EPS

Stockholders

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.

Degree of Financial Leverage

DFL = % change in EPS % change in EBIT

Degree of Financial Leverage

DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT

Degree of Financial Leverage

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

Degree of Financial Leverage

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

EBIT DFL = EBIT - I

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.

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.

Sales

EBIT

EPS

Stockholders

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.

Sales

EBIT

EPS

Stockholders

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.

Degree of Combined Leverage

Degree of Combined Leverage

DCL = DOL x DFL

Degree of Combined Leverage

DCL = DOL x DFL % change in EPS = % change in Sales

Degree of Combined Leverage

DCL = DOL x DFL % change in EPS = % change in Sales change in EPS EPS change in Sales Sales

Degree of Combined Leverage

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

Degree of Combined Leverage

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

DCL =

Sales - Variable Costs EBIT - I

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

What does this tell us?

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

What does this tell us?

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

Sales

EBIT

EPS

Stockholders

What does this tell us?

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

Sales

EBIT

EPS

Stockholders

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?

Levered Company
Sales (100,000 units) Variable Costs Fixed Costs Interest paid Tax rate Common shares outstanding $1,400,000 $800,000 $250,000 $125,000 34% 100,000

Leverage Sales
DCL DOL

EPS

DFL

EBIT

Levered Company Sales

DCL DOL =

EPS

DFL

EBIT

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs DOLs = EBIT

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs DOLs = EBIT = 1,400,000 - 800,000 350,000

Degree of Operating Leverage

from Sales Level (S)

Sales - Variable Costs DOLs = EBIT = 1,400,000 - 800,000 350,000 = 1.714

Levered Company Sales

DCL DOL = 1.714

EPS

DFL =

EBIT

Degree of Financial Leverage

EBIT DFL = EBIT - I

Degree of Financial Leverage

EBIT DFL = EBIT - I = 350,000 225,000

Degree of Financial Leverage

EBIT DFL = EBIT - I = 350,000 225,000 = 1.556

Levered Company Sales

DCL DOL = 1.714

EPS

DFL = 1.556

EBIT

Degree of Combined Leverage

DCL = Sales - Variable Costs EBIT - I

Degree of Combined Leverage

DCL = = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000

Degree of Combined Leverage

DCL = = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667

Levered Company Sales

DCL = 2.667 DOL = 1.714

EPS

DFL = 1.556

EBIT

Levered Company
10% increase in sales

Sales (110,000 units) Variable Costs Fixed Costs EBIT Interest EBT Taxes (34%) Net Income EPS

1,540,000 (880,000) (250,000) 410,000 ( +17.14%) (125,000) 285,000 (96,900) 188,100 $1.881 ( +26.67%)