Chapter 15 – Analysis and Impact of Leverage

What is Leverage  Company A: sales increases 2.9 percent, but net income increases 16.9 percent.  Company B: sales decreases 3.6 percent, but net income decreases 19.4 percent.

Two 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). FIRM EBIT EPS Stock-holders

Business Risk Affected by:  Sales volume variability  Competition  Product diversification  Operating leverage  Growth prospects  Size

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.

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).

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.

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).

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

Quantity { $ Total Revenue Total Cost FC Break- even point Q1Q1 + - } EBIT

Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q1Q1 + - EBIT

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

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

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

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.

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) 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). 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.

DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT Degree of Financial Leverage =

DFL = EBIT EBIT - I  If we have the data, we can use this formula:

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.

DCL = DOL x DFL Degree of Combined Leverage = % 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: 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. 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

EPS Financial leverage Operating Income Sales Operating leverage Levered Company

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

EPS Operating Income Sales Operating leverage 10% 17.14% Levered Company

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

EPS Financial leverage Operating Income Sales 10% 15.56% Levered Company

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 = =

EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage Levered Company

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