1. Operating and Financial Leverage
Chapter 5
Operating and Financial Leverage

2. Chapter 5 - Outline What is Leverage? Break-Even (BE) Point
Operating Leverage
Financial Leverage
Leverage Means Risk
Combined or Total Leverage

3. What is Leverage?
Use of special forces and effects to magnify or produce more than the normal results from a given course of action
Leverage involves using fixed costs to magnify the potential return to a firm
Can produce beneficial results in favorable conditions
Can produce highly negative results in unfavorable conditions

4. Leverage in a Business Determining type of fixed operational costs
Plant and equipment
Can reduce expensive labor in production of inventory
Expensive labor
Lessens opportunity for profit but reduces risk exposure
Determining type of fixed financial costs
Debt financing
Can produce substantial profits, but failure to meet contractual obligations can result in bankruptcy
Selling equity
May reduce potential profits for existing shareholders, but reduces their risk exposure

5. Break-Even (BE) Point Quantity where Total Revenue equals Total Cost
Company has no Profit or Loss
BE = FC / (P – VC)
A leveraged firm has a high BE point
A non-leveraged firm has a low BE point

6. FIGURE 5-1
Break-even chart: Leveraged firm

7. FIGURE 5-2
Break-even chart: Conservative firm

8. TABLE 5-2
Volume-cost-profit analysis: Leveraged firm

9. TABLE 5-3
Volume-cost-profit analysis: Conservative firm

10. FIGURE 5-3
Nonlinear break-even analysis

11. Operating Leverage
Measure of the amount of fixed operating costs used by a firm.
Degree of Operating Leverage (DOL) = % in EBIT (or Operating Income) / %  in Sales
DOL = Q(P-VC) / (Q(P-VC) –FC)
Operating Leverage measures the sensitivity of a firm’s operating income to a  in sales.

12. TABLE 5-4
Operating income or loss

13. Financial Leverage Measure of the amount of debt used by a firm
Degree of Financial Leverage (DFL) = % in EPS / %  in EBIT (or Operating Income)
DFL = EBIT / (EBIT –I)
Financial Leverage measures the sensitivity of a firm’s earnings per share to a  in operating income

14. Leverage Means Risk Leverage is a double-edged sword
It magnifies profits as well as losses
An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point)
A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)
Many Japanese firms tend to be highly leveraged

15. FIGURE 5-4
Financing plans and earnings per share

16. TABLE 5-5
Impact of financing plan on earnings per share

17. Financial Leverage
Reflects the amount of debt used in the capital structure of the firm
Determines how the operation is to be financed
Determines the performance between two firms having equal operating capabilities
BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

18. TABLE 5-6
Income statement

19. Combined or Total Leverage
Represents maximum use of leverage
Degree of Combined or Total Leverage (DCL or DTL) = % in EPS / % in Sales
DCL= Q(P-VC)/(Q(P-VC)-FC-I)
= (S-TVC) /( S-TVC –FC- I)
Short-cut formula:
DCL or DTL = DOL x DFL

20. TABLE 5-7
Operating and financial leverage

21. Combining Operating and Financial Leverage
Combined leverage: when both leverages allow a firm to maximize returns
Operating leverage:
Affects the asset structure of the firm
Determines the return from operations
Financial leverage:
Affects the debt-equity mix
Determines how the benefits received will be allocated