Presentation on theme: "Operating and Financial Leverage"— Presentation transcript:
1 Operating and Financial Leverage Chapter 5Operating and Financial Leverage
2 Chapter 5 - Outline What is Leverage? Break-Even (BE) Point Operating LeverageFinancial LeverageLeverage Means RiskCombined 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 actionLeverage involves using fixed costs to magnify the potential return to a firmCan produce beneficial results in favorable conditionsCan produce highly negative results in unfavorable conditions
4 Leverage in a Business Determining type of fixed operational costs Plant and equipmentCan reduce expensive labor in production of inventoryExpensive laborLessens opportunity for profit but reduces risk exposureDetermining type of fixed financial costsDebt financingCan produce substantial profits, but failure to meet contractual obligations can result in bankruptcySelling equityMay 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 LossBE = FC / (P – VC)A leveraged firm has a high BE pointA non-leveraged firm has a low BE point
11 Operating LeverageMeasure of the amount of fixed operating costs used by a firm.Degree of Operating Leverage (DOL) = % in EBIT (or Operating Income) / % in SalesDOL = Q(P-VC) / (Q(P-VC) –FC)Operating Leverage measures the sensitivity of a firm’s operating income to a in sales.
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 lossesAn 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 5-4Financing plans and earnings per share
16 TABLE 5-5Impact of financing plan on earnings per share
17 Financial LeverageReflects the amount of debt used in the capital structure of the firmDetermines how the operation is to be financedDetermines the performance between two firms having equal operating capabilitiesBALANCE SHEETAssets Liabilities and Net WorthOperating leverage Financial leverage
19 Combined or Total Leverage Represents maximum use of leverageDegree of Combined or Total Leverage (DCL or DTL) = % in EPS / % in SalesDCL= Q(P-VC)/(Q(P-VC)-FC-I)= (S-TVC) /( S-TVC –FC- I)Short-cut formula:DCL or DTL = DOL x DFL
21 Combining Operating and Financial Leverage Combined leverage: when both leverages allow a firm to maximize returnsOperating leverage:Affects the asset structure of the firmDetermines the return from operationsFinancial leverage:Affects the debt-equity mixDetermines how the benefits received will be allocated
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