1. Operating Leverage Financial Leverage Ch. 15: Analysis and
Impact of Leverage
Operating Leverage
Financial Leverage
 2002, Prentice Hall, Inc.

2. What is Leverage?

3. What is Leverage?

4. What is Leverage?

5. 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.

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

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

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

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

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

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

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

13. 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.

15. EBIT
Operating
Leverage

16. 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.

17. 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

18. 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

19. Financial Leverage
The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

21. EPS
Financial
Leverage

22. 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

23. Breakeven Analysis
Quantity $

24. Quantity $
Total Revenue

25. 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).

26. Quantity $
Total Revenue

27. Quantity { $
Total Revenue
Total Cost FC

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

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

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

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

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

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

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

35. } { 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!

36. Breakeven Calculations

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

38. 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

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

40. 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 -

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

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

43. 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

44. 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.

45. Degree of Operating Leverage from Sales Level (S)
% change in EBIT
% change in sales
DOLs =

46. Degree of Operating Leverage from Sales Level (S)
% change in EBIT
% change in sales
DOLs =
change in EBIT
EBIT
change in sales
sales =

47. Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:

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

49. 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

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

51. 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

52. 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

53. 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.

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

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

56. Degree of Financial Leverage
If we have the data, we can use this formula:

57. Degree of Financial Leverage
If we have the data, we can use this formula:
DFL =
EBIT
EBIT - I

58. 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.

59. 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

60. 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

61. 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.

62. Degree of Combined Leverage

63. Degree of Combined Leverage
DCL = DOL x DFL

64. Degree of Combined Leverage
DCL = DOL x DFL
% change in EPS
% change in Sales =

65. Degree of Combined Leverage
DCL = DOL x DFL =
% change in EPS
% change in Sales
change in EPS
EPS
change in Sales
Sales

66. Degree of Combined Leverage
If we have the data, we can use this formula:

67. Degree of Combined Leverage
If we have the data, we can use this formula:
DCL =
Sales - Variable Costs
EBIT - I

68. 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 =

69. What does this tell us?
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.

70. 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

71. 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

72. 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?

73. Levered Company Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate %
Common shares outstanding ,000

74. Leverage
Sales
EBIT
EPS
DOL
DFL
DCL

75. Levered Company
Sales
EBIT
EPS
DOL =
DFL
DCL

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

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

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

79. Levered Company
Sales
EBIT
EPS
DOL = 1.714
DFL =
DCL

80. Degree of Financial Leverage
DFL =
EBIT
EBIT - I

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

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

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

84. Degree of Combined Leverage
DCL =
Sales - Variable Costs
EBIT - I

85. Degree of Combined Leverage
DCL =
Sales - Variable Costs
EBIT - I
1,400, ,000
225,000 =

86. Degree of Combined Leverage
DCL =
Sales - Variable Costs
EBIT - I
1,400, ,000
225,000 = =

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

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