Leverage. 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 Leverage:
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Total Revenue
(PQ)
$
Quantity
Breakeven Analysis
Total Revenue
Total Cost
(QV)+F or
VC+F
$
{
FC
Quantity
Breakeven Analysis
}
+
EBIT

Q1
Breakeven EBIT
Total Revenue
$
EBIT
+
Total Cost
= Fixed

FC
Q1
Quantity
Breakeven Analysis
}
With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Tradeoff: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!
{
Breakeven EBIT
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
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?
Sales (100,000 units)$1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Shares outstanding 100,000
Sales
DCL
DOL
EPS
EBIT
DFL
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
Tax @ 34% ($75,500)
EAT (Net Income) $148,500
EPS = $148,500 / 100,000 = $1.485
Degree of Financial Leverage
Sales
DCL = 2.667
DOL = 1.714
EPS
EBIT
DFL =
1.556
Sales (110,000 units)1,540,000
Variable Costs (880,000)
Fixed Costs (250,000)
EBIT 410,000 ( +17.14%)
Interest(125,000)
EBT 285,000
Taxes (34%) (96,900)
Net Income 188,100
EPS $1.881 ( +26.67%)