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

2. Leverage Analysis Operating Leverage Financial Leverage
Affects a firm’s business risk
Business risk is the variability or uncertainty of a firm’s operating income (EBIT)
Financial Leverage
Affects a firm’s financial risk
Financial risk is 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

3. Illustrates the effects of operating 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
Terms:
P: price per unit, Q: quantity produced, V: variable costs per unit, VC; total variable costs, F; total fixed costs, TC: total cost (VC+F), S: sales ($)

4. Breakeven Analysis
Quantity $
Total Revenue
(PQ)

5. 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)

6. } - { Breakeven Analysis + Q1 Total Revenue Total Cost $ (QV)+F or
Quantity { $
Total Revenue
Total Cost
(QV)+F or
VC+F FC } +
EBIT - Q1
Breakeven EBIT

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

8. } { Breakeven Analysis Total Revenue $ EBIT + Total Cost = Fixed - FC
With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Quantity $
Total Revenue
Total Cost
= Fixed FC 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 EBIT

9. Breakeven Calculations – Quantity

10. Breakeven Calculations – Sales

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

12. 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

13. Degree of Operating Leverage from Sales Level (S)
Above calculation requires two analytical income statements, one for the base period and one for the following period using the new level of sales

14. Degree of Operating Leverage from Sales Level (S)
If we have the base level data, we can use this formula:
Implicit assumption is that Variable Costs / Sales and Fixed Costs stay the constant
If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT) and vice versa
%Δ in EBIT = DOLSales x %Δ in Sales

15. 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 (EPS)
This “multiplier effect” is called the degree of financial leverage

16. Degree of Financial Leverage
Each financing or capital structure (relative use of debt and equity) alternative will have a different degree of financial leverage (DFL)

17. Degree of Financial Leverage
Instead of calculating DFL for each alternative capital structure we can use the following formula with the base EBIT and differing interest expenses
Note that interest expense would be based on how much debt is used financing the assets of the firm
If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share and vice versa
%Δ in EPS = DFLEBIT x %Δ in EBIT

18. 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

19. Degree of Combined Leverage

20. Degree of Combined Leverage
If we have the base level data, we can use this formula:
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share
%Δ in EPS = DCLSales x %Δ in Sales

21. Example
Based on the following information on a 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?

22. Levered Company – Data
Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate %
Shares outstanding ,000

23. Leverage
Sales
EBIT
EPS
DOL
DFL
DCL

24. Levered Company – Base Level Data
Sales (100,000 units) $1,400,000
Variable Costs ($800,000)
Fixed Costs ($250,000)
EBIT (Operating Income) $350,000)
Interest paid ($125,000)
EBT $225,000
34% ($75,500)
EAT (Net Income) $148,500
EPS = $148,500 / 100,000 = $1.485

25. Degree of Operating Leverage from Sales Level (S)
Answer to part 1:
%Δ in EBIT = DOLSales x %Δ in Sales
%Δ in EBIT = x 10% = 17.14%

26. Degree of Financial Leverage
Answer to part 2:
%Δ in EPS = DFLEBIT x %Δ in EBIT
%Δ in EPS = x 10% = 15.56%
%Δ in EPS = x 17.14% = 26.67% (cumulative impact of part 1

27. Degree of Combined Leverage
Answer to part 3:
Alternatively DCL = DOL x DFL
DCL = x = 2.667
%Δ in EPS = x 10% = 26.67%

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

29. 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 $ ( %)