1 Operating Leverage Financial Leverage

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

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

4 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.

5 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

6 Financial Leverage The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock). A firm with relatively high fixed financing costs will experience more net income if EBIT changes.

7 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).

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

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

10 Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

11 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

12 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 -

13 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.

14 DOLs = % change in EBIT % change in sales = Degree of Operating Leverage from Sales Level (S) Sales - Variable Costs EBIT Q(P - V) Q(P - V) - F =

15 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

16 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.

17 DFL = % change in EPS % change in EBIT EBIT EBIT - I Degree of Financial Leverage =

18 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

19 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.

20 DCL = DOL x DFL Degree of Combined Leverage = % change in EPS % change in Sales Sales - Variable Costs EBIT - I = = Q(P - V) Q(P - V) - F - I

21 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

22 In-class Project: Based on the following information on Levered Company, answer these questions: 1) If sales increase by 1%, what should happen to operating income? 2) If operating income increases by 1%, what should happen to EPS? 3) If sales increase by 1%, what should be the effect on EPS?

23 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

24 Sales EBIT EPS DOL DFL DCL Leverage

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

26 Levered Company Sales EBIT EPS DOL = DFL = DCL

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

28 Levered Company Sales EBIT EPS DOL = DFL = DCL

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

30 Levered Company Sales EBIT EPS DOL = DFL = DCL = 2.667

31 Sales (110,000 units)1,414,000 Variable Costs (808,000) Fixed Costs (250,000) EBIT 356,000 ( %) Interest (125,000) EBT 231,000 Taxes (34%) (78,540) Net Income 152,460 EPS $ ( %) Levered Company 1% increase in sales