Operating Leverage Financial Leverage Ch. 15: Analysis and Impact of Leverage 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 firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.

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

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

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

Business Risk The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS

Business Risk The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock- holders

Business Risk The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock- holders

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 firm’s 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 firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock- holders

Financial Risk The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock- holders

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. 12

Breakeven Analysis Quantity $

Quantity $ Total Revenue

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).

Quantity $ Total Revenue

Quantity { $ Total Revenue Total Cost FC

Quantity { $ Total Revenue Total Cost FC } EBIT + - Q1

} { EBIT + - Q1 Total Cost $ FC Quantity Total Revenue Break- even point Q1 + - } EBIT

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

} { EBIT + - Q1 Total Cost $ FC Quantity Total Revenue Break- even point Q1 + - } EBIT

} { EBIT + - Q1 $ Total Cost = Fixed FC Quantity Total Revenue Break- point } Q1 + - EBIT

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

} { EBIT + - Q1 $ Total Cost = Fixed FC Quantity Total Revenue Break- point } Q1 + - EBIT

} { EBIT + - Q1 Trade-off: the firm has a higher breakeven $ Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q1 + - EBIT Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Breakeven Calculations

Breakeven Calculations Breakeven point (units of output) QB = F P - V

Breakeven Calculations Breakeven point (units of output) QB = breakeven level of Q. F = total anticipated fixed costs. P = sales price per unit. V = variable cost per unit. QB = F P - V

Breakeven Calculations Breakeven point (sales dollars) S* = F VC S 1 -

Breakeven Calculations Breakeven point (sales dollars) S* = breakeven level of sales. F = total anticipated fixed costs. S = total sales. VC = total variable costs. S* = F VC S 1 -

Analytical Income Statement sales - variable costs - fixed costs operating income - interest EBT - taxes net income

Analytical Income Statement sales - variable costs - fixed costs operating income - interest EBT - taxes net income } contribution margin

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

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) % change in EBIT % change in sales DOLs =

Degree of Operating Leverage from Sales Level (S) % change in EBIT % change in sales DOLs = 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: DOLs = Sales - Variable Costs EBIT

Degree of Operating Leverage from Sales Level (S) If we have the data, we can use this formula: Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs 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).

What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

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 % change in EPS % change in EBIT DFL =

Degree of Financial Leverage % change in EPS % change in EBIT DFL = 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: DFL = EBIT 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. Stock- holders EBIT EPS Sales

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. Stock- holders EBIT EPS Sales

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. Stock- holders EBIT EPS Sales

What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales

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

Leverage Sales EBIT EPS DOL DFL DCL

Levered Company Sales EBIT EPS DOL = DFL DCL

Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT

Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = DOLs = Sales - Variable Costs EBIT

Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT

Levered Company Sales EBIT EPS DOL = 1.714 DFL = DCL

Degree of Financial Leverage DFL = EBIT EBIT - I

Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000

Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000 = 1.556

Levered Company Sales EBIT EPS DOL = 1.714 DFL = 1.556 DCL

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 EBIT EPS DOL = 1.714 DFL = 1.556 DCL = 2.667

Levered Company 10% increase in sales Sales (110,000 units) 1,540,000 Variable Costs (880,000) Fixed Costs (250,000) EBIT 410,000 ( +17.14%) Interest (125,000) EBT 285,000 Taxes (34%) (96,900) Net Income 188,100 EPS $1.881 ( +26.67%)