Leverage
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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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Leverage

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Leverage

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:

    • The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock)


Leverage analysis

Leverage Analysis

  • Operating 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


Breakeven analysis

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 ($)


Leverage

Total Revenue

(PQ)

$

Quantity

Breakeven Analysis


Costs

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)


Leverage

Total Revenue

Total Cost

(QV)+F or

VC+F

$

{

FC

Quantity

Breakeven Analysis

}

+

EBIT

-

Q1

Breakeven EBIT


Operating leverage

Operating Leverage

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


Leverage

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.

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


Breakeven calculations quantity

Breakeven Calculations – Quantity


Breakeven calculations sales

Breakeven Calculations – Sales


Analytical income statement

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


Degree of operating leverage dol

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


Degree of operating leverage from sales level s

Degree of Operating Leveragefrom 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


Degree of operating leverage from sales level s1

Degree of Operating Leveragefrom 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


Degree of financial leverage dfl

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


Degree of financial leverage

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)


Degree of financial leverage1

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


Degree of combined leverage dcl

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


Degree of combined leverage

Degree of Combined Leverage


Degree of combined leverage1

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


Example

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?


Levered company data

Levered Company – Data

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


Leverage1

Sales

DCL

DOL

EPS

EBIT

DFL

Leverage


Leverage

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 operating leverage from sales level s2

Degree of Operating Leverage from Sales Level (S)

  • Answer to part 1:

  • %Δ in EBIT = DOLSales x %Δ in Sales

  • %Δ in EBIT = 1.714 x 10% = 17.14%


Leverage

Degree of Financial Leverage

  • Answer to part 2:

  • %Δ in EPS = DFLEBIT x %Δ in EBIT

  • %Δ in EPS = 1.556 x 10% = 15.56%

  • %Δ in EPS = 1.556 x 17.14% = 26.67% (cumulative impact of part 1


Degree of combined leverage2

Degree of Combined Leverage

  • Answer to part 3:

  • Alternatively DCL = DOL x DFL

  • DCL = 1.714 x 1.556 = 2.667

  • %Δ in EPS = 2.667 x 10% = 26.67%


Levered company

Sales

DCL = 2.667

DOL = 1.714

EPS

EBIT

DFL =

1.556

Levered Company


Levered company 10 increase in sales

Levered Company10% increase in sales

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%)


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