1. Ch16 Operating and Financial Leverage Prepared by: Chara Charalambous CDA COLLEGE Cost Structure and Dividend Decision Cost Structure and Dividend Decision Chara Charalambous

2. Chapter 16 - Outline What is Leverage? Break-Even Analysis Operating Leverage Risk Analysis of Leverage Financial Leverage Indifference Point Combined or Total Leverage Summary and Conclusions Chara Charalambous

3. Learning Objectives 1.Define leverage as a method to magnify earnings available to the firm’s common shareholders. (LO1) 2.Define and calculate operating leverage and assess its opportunities and limitations. (LO2) 3.Define and calculate financial leverage and assess its opportunities and limitations. (LO3) Chara Charalambous

4. Learning Objectives 4.Calculate the indifference point between financing plans using EBIT/EPS analysis. (LO4) 5.Define and calculate combined leverage. (LO5) Chara Charalambous

5. A SIMPE CALCULATION OF NET PROFIT SALES LESS: EXPENSES NET PROFIT (LOSS) Chara Charalambous

6. But expenses are classified into two broad categories: Fixed Expenses and Variable Expenses! TOTAL FIXED EXPENSES: are costs/expenses that tend to remain the same regardless of production. Such examples are rents, advertising, depreciation, salaries of managers, board of directors and employees related to the administration of the company, insurance e.t.c. TOTAL VARIABLE EXPENSES: are those expenses/costs that vary- fluctuate depending on a company’s level of production. They rise as production increases and fall as production decreases. Examples could be direct raw materials, direct labor ( workers or touch labor) who are directly involved with the manufacture of goods, some manufacture overheads, shipping costs, sales commissions’ e.t.c. If a company pays rent every month €250 and also €8 per product produced to workers. Which one is fixed and which one is variable? Chara Charalambous

7. So the income statement can be written as: Sales — Variable costs Contribution margin — Fixed costs Net Operating income or EBIT Chara Charalambous Contribution Margin: represents the portion of sales that is not consumed by variable costs and so contributes to the coverage of fixed costs.

8. Solve this……….. Example: PNG electric company manufactures a number of electric products. Rechargeable light is one of the PNG’s products that sell for €180/unit. Total fixed expenses related to rechargeable electric light are €270,000 per month and variable expenses involved in manufacturing this product are €126 per unit. Monthly sales are 8,000 rechargeable lights. Prepare the income statement of this company. Chara Charalambous

9. Repeat….. A firm’s operational costs may be classified as: -- fixed: those costs that remain the same in the short run (e.g.: rental, amortization, executive salaries, property taxes) -- variable: those costs that change as production/sales changes (e.g. raw material, factory labour, sales commissions) -- semi variable: those costs that may change but not directly related to production/sales (e.g. utilities, repairs and maintenance) Fixed costs are expenses that do not change based on production levels. This does not mean these expenses are written in stone; sometimes rent goes up or insurance premiums go down. Instead, the term "fixed" applies to the absence of a relationship between the amount of the expense and the number of items produced. If the company makes 100 rocking chairs or 1,000, rent is paid for use of the factory or warehouse either way. Other common fixed cost expenses are advertising costs, payroll for salaried employees or those whose wages do not change with production levels, payroll taxes, employee benefits and office supplies. Chara Charalambous

10. But there are more expenses for a company related to the finance of the firm like financial expenses: interest of loans, tax and dividends. So a complete financial statement is given below: Sales — Variable costs Contribution margin — Fixed costs Operating income or EBIT — Interest Expense EBT: Earnings before taxes — Taxes EAT: Earnings after taxes — Dividends of preference shares Earnings available to common shareholders Number of ordinary Shares EPS: Earnings per share= Earnings available to common shareholders Number of ordinary Shares. Chara Charalambous

11. EBIT: Earnings before interest and taxes Capital Structure: In finance capital structure refers to the way a business finances its assets through some combination of equity and debt. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt- financed. In reality, capital structure may be highly complex and include dozens of sources. Explanation of terms:

12. Break-Even Analysis Break-even analysis is the technique used to study the effect of sales volume on costs and profit. The interesting sales volume is the break-even (BE) sales level, at which a firm’s total revenue equals total cost, that is, the firm does not make money nor lose money (breaks even) LO2 Chara Charalambous Break Even Point: is the point at which I have no profit and no loss. The result is zero.

13. Chara Charalambous Example: Pringle Company sells a single product. The company's sales and expenses for the recent year follow : Solve this………….. Total Per Unit Sales (15000 units) $600,000$40.00 less Variable Expenses $420,000$28.00 Contribution Margin$180,000$12.00 less fixed expenses$150,000 EBIT $30,000 What is the monthly break-even point in units sold and in sales dollars?

14. Break even point is the number of units sold at which the company has neither profit nor loss but it just covers all of its costs. Chara Charalambous Two methods to compute Break-even-point: A) The equation method and B) The contribution margin method

15. 15 A) The equation method: Profit= Sales – variable costs – fixed costs therefore Sales= Profits + variable costs +fixed costs Example: The A company is selling one unit of its product for €250. it has variable expenses €150 per unit and total fixed expenses €35000. What is the level of sales at which it has break even? Q*250=Q*150+35000+0 =>Q*250-Q*150=35000 =>100Q=35000 =>Q=350 total units So the break even in total euro sales is 350*250= €87500 Chara Charalambous

16. 16 B) The contribution margin method: Is based on the idea show at the beginning where:each unit sold gives a certain amount of contribution margin that goes toward covering fixed costs. Break-even-point = Fixed Expenses Contribution margin per unit Example 1 slide 15: BEP=35000=350 units 100 If we wish to find the BEP in total euro sales, which is useful for companies that have multiple product lines and they want to compute a single break even point for the company as a whole, we use the following Calculation: Break-even-point = Fixed Expenses CM Ratio Chara Charalambous CM RATIO = CONTRIBUTION MARGIN SALES

17. Summary : A firm is less exposed to downturns if It has lower fixed expenses, lower break even sales (75000 instead of 85714). It will not incur losses as quickly as other firms with higher BEP and higher FC in periods where sales decline a lot. Thus the firm’s income is less unstable. On the one hand this is a disadvantage in cases of sales increase but it provides more protection when sales drop. Chara Charalambous

18. Table -2 Volume-cost-profit analysis: leveraged firm TotalOperating Units VariableFixedTotalTotalIncome Sold CostsCosts Costs Revenue(loss) 00$60,000$ 60,000 0$(60,000) 20,000 16,000 60,000 76,000$ 40,000(36,000) 40,00032,00060,000 92,000 80,000(12,000) 50,00040,00060,000100,000100,000 0 60,00048,00060,000108,000120,000 12,000 80,00064,00060,000124,000160,000 36,000 100,00080,00060,000140,000200,000 60,000 LO2 Chara Charalambous

19. FIGURE 1 Break-even chart: Leveraged firm LO2 Chara Charalambous

20. Table 3 Volume-cost-profit analysis: conservative firm 00 $12,000 $12,000 0$(12,000) 20,000$ 32,00012,000 44,000$ 40,000 (4,000) 30,000 48,00012,000 60,000 60,000 0 40,000 64,00012,000 76,000 80,000 4,000 60,000 96,00012,000108,000120,00012,000 80,000128,00012,000140,000160,00020,000 100,000160,00012,000172,000200,00028,000 Total Operating UnitsVariable FixedTotalTotal Income SoldCostsCosts Costs Revenue (loss) LO2 Chara Charalambous

21. FIGURE 2 Break-even chart: Conservative firm LO2 Chara Charalambous

22. 22 Conclusion: Without knowing the future it is not obvious which cost structure is better. Both have advantages and disadvantages. A company with higher fixed cost and lower variable costs will experience wider changes in net profit as changes take place in sales: great profits in good years, great losses in bad years. A company with lower fixed costs and higher variable costs will enjoy grater stability in net profit and will be more protected from losses in bad years but it will have lower profits in good years. Chara Charalambous

23. 23 Operating Leverage  A lever is a tool for multiplying force. (acts as a multiplier) Using a lever, a massive object can be moved with only an ordinary amount of force. Chara Charalambous  In business, operating leverage serves a similar purpose.

24. What is Leverage? Leverage is using fixed costs to magnify the potential return to a firm Magnify= enlarge, expand, increase, zoom 2 types of fixed costs: 1.fixed operating costs = rent, depreciation e.t.c 2.fixed financial costs = interest costs from debt LO1 Chara Charalambous

25. Why? Operating Leverage: The use of fixed operating costs by the firm. One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss) As sales increases fixed costs remain the same so we have more profits. Variable costs do not serve this purpose because they increase as sales increases. Chara Charalambous

26. 26 Operating Leverage Degree of Operating Leverage is the effect that a specific amount of operating leverage (fixed expenses) has on a company’s earnings before interest and taxes. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. Operating leverage is a measure of how sensitive net profit is to a given percentage change in euro sales Chara Charalambous

27. What is Leverage? 2 types of leverage: 1.Operating Leverage = the extent to which fixed assets and associated fixed costs are utilize 2.Financial Leverage = the amount of debt used in the capital structure (debt/equity mix) LO1 Chara Charalambous

28. Sales (total revenue) (80,000 units @ $2)$160,000 — Variable costs ($0.80 per unit)64,000 Contribution margin 96,000 — Fixed costs60,000 Operating income 36,000 Earnings before interest and taxes 36,000 — Interest Expense12,000 Earnings before taxes24,000 — Taxes12,000 Earnings aftertaxes$ 12,000 Shares8,000 Earnings per share$1.50 Operating leverage (trading and P&L up to the point we find N.P) Financial leverage Table 1 Income statement LO1 Chara Charalambous

29. ©2009 McGraw-Hill Ryerson Limited 3 ways to calculate DOL Chara Charalambous

30. 30 1. The Degree of operating leverage at a given level of sales is computed by the following formula: (if the company we study sells more than one product : is a multiproduct firm) Degree of operating leverage = Contribution Margin Net Operating Income (EBIT) OR DOL = EBIT + FC (is the same thing as above) EBIT –The degree of operating leverage is a measure, at a given level of sales, of how percentage change in sales volume will affect profits. Chara Charalambous at $ dollars of sales

31. 2. Percentage change in Operating Income ( EBIT ) for a given percentage in Sales: DOL at Q units of output (or sales) = % Δ EBIT % Δ Sales The sensitivity of the firm to a change in sales as measured by DOL will be different at each level of output (or sales). Therefore, we always need to indicate the level of output (or sales) at which DOL is measured – as in DOL at Q units. Chara Charalambous

32. 3. Quantity Method DOL = Q (if single product company) Q – Q Chara Charalambous BE at Q units of output (or s ales)

33. The answer given to us, what ever method we use,is: Degree of operating leverage (DOL): The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output (sales). Chara Charalambous

34. Question: What does “DOL5,000 units = 5” really mean? Answer: It means that a 1 percent change in sales from the 5,000-unit sales position causes a 5 percent change in EBIT. In fact, any percentage change in sales from the 5,000-unit position causes a percentage change in EBIT that is five times as large. For example, a 3 percent decrease in sales causes a 15 percent decrease in EBIT, and a 4 percent increase in sales causes a 20 percent increase in EBIT. Chara Charalambous

35. Question: How would knowledge of a firm’s DOL be of use to a financial manager? Answer: The manager would know in advance what impact a potential change in sales would have on operating profit. Sometimes, in response to this advance knowledge, the firm may decide to make some changes in its sales policy and/or cost structure. As a general rule, firms do not like to operate under conditions of a high degree of operating leverage because, in that situation, a small drop in sales may lead to an operating loss. As operating leverage is the use of fixed expenses the higher the DOL the more sensitive the EBIT amount will be when the sales amount change. So DOL shows how sensitive the operating profit (EBIT) is to a change in the company’s sales. Chara Charalambous

36. Distinguish between operating leverage and financial leverage. Both operating and financial leverage result in the magnification (enlargement) of changes to earnings due to the presence of fixed costs in a company's cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statement - how EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statement - how earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest. Chara Charalambous

37. No fixed financing costs. A firm with no fixed financing costs has no financial leverage. In such a firm, earnings per share will rise and fall with EBIT by the same percentage. For example, a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in EBIT will result in a 9% decrease in EPS. Chara Charalambous

38. The Effect of Financial Leverage: How does leverage affect the EPS of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs (same amount as above point) and we have less left over for our stockholder Leverage magnifies the variation in EPS Chara Charalambous

39. Risk Analysis of Leverage A leveraged firm has high fixed costs, a high BE point and high DOL. A non-leveraged firm has low fixed costs, a low BE point and low DOL. Leverage is a double-edged sword. It magnifies losses as well as profits. LO2 Chara Charalambous

40. When comparing firms, the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales. DOL is only one component of business risk and becomes “active” only in the presence of sales and production cost variability. DOL magnifies the variability of operating profits and, hence, business risk.

41. Financial Leverage Measure of the amount of debt used by a firm Degree of Financial Leverage (DFL) = %age  in EPS %age  in EBIT (or OI) a  in EBIT (or OI)  a larger  in EPS if DFL > 1 DFL measures the sensitivity of a firm’s earnings per share to a  in operating income. LO3 Chara Charalambous

42. TABLE 4 Impact of financing plan on earnings per share LO4 Chara Charalambous

43. Indifference Point IF I WANT TO CHOOSE BETWEEN TWO ALTERNATIVES OF FINANCING for example to choose equity or debt structure: issue ordinary shares or issue bonds? AND I DO NOT KNOW WHICH ONE IS BETTER SO I WANT TO FIND AT WHICH LEVEL OF EBIT IT DOESN’T MAKE ANY SENSE TO ME WHATEVER I CHOOSE. THE RESULT FOR MY COMPANY WILL BE THE SAME – EPS WILL BE THE SAME. What do I do? Chara Charalambous

44. If I have two options……. I need to find the EBIT amount at which it will not make any sense to me – any difference - whether I choose the one or the other because EPS will be the same for both. ( Indifferent= αδιάφορος) Is the amount of EBIT at which EPS is the same for two alternatives /options Chara Charalambous

45. Indifference Point – or EBIT – EPS Break Even Analysis or Indifferent Analysis The break-even point is the EBIT level where EPS is the same for two (or more) alternatives. The formula to find this point is: EBIT – Interest – (EBIT-Interest)*tax% = EBIT – Interest – (EBIT-Interest)*tax% Number of Shares Number of Sha res Alternative 1 Alternative 2: The unknown factor in this case is EBIT

46. Indifference Point the level of EBIT at which alternative financing plans yield the same earnings per share (EPS) Mathematically, LO4 Chara Charalambous

47. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives.

48. Figure 3 Financial leverage in selected industries LO4 Source: Statistics Canada, “Quarterly Financial Statistics for Enterprises”, Catalogue 61-008-X, First quarter, 2008 Chara Charalambous

49. Combined or Total Leverage Represents maximum use of leverage Degree of Combined Leverage (DCL ) = %age  in EPS %age  in Sales a  in Sales  a larger  in EPS if DCL > 1 Short-cut formula: DCL or DTL = DOL x DFL LO5 Chara Charalambous

50. Table 5 Operating and financial leverage Sales — $2 per unit $160,000$200,000 — Variable costs ($0.80 per unit)64,00080,000 Contribution margin $96,000 $120,000 — Fixed costs 60,00060,000 Operating income (EBIT) 36,00060,000 — Interest12,00012,000 Earnings before taxes24,00048,000 — Taxes12,00024,000 Earnings after taxes$ 12,000$ 24,000 Shares8,0008,000 Earnings per share$1.50$3.00 (80,000 units)(100,000 units) (Taken from Table 5-6) LO5 Chara Charalambous

51. Formula Review LO2/LO3/LO4 DCL = DOL × DFL Chara Charalambous

52. Summary and Conclusions Leverage refers to the use of fixed costs to magnify the profits (or losses) of a firm It is a double-edged sword-tool.. Management must be sure of the level of risk assumed Operating leverage refers to using fixed operating costs, such as lease or amortization expense The degree of operating leverage (DOL) measures the %age change in operating income as a result of a %age change in sales Chara Charalambous

53. Summary and Conclusions Financial leverage refers to the fixed financing charge such as interest cost on debt The degree of financial leverage (DFL) measures the %age change in earnings per share (EPS) as a result of a %age change in operating income The higher the level of fixed costs (both operating and financing costs), the greater the effect on net income of an increase in sales revenue (This is the degree of combined leverage (DCL)) Chara Charalambous