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Chapter 5. Operating and Financial Leverage. Chapter 5 - Outline . What is Leverage? Break-Even (BE) Point Operating Leverage Financial Leverage Leverage Means Risk Combined or Total Leverage. What is Leverage?.

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chapter 5

Chapter 5

Operating and FinancialLeverage

chapter 5 outline
Chapter 5 - Outline
  • What is Leverage?
  • Break-Even (BE) Point
  • Operating Leverage
  • Financial Leverage
  • Leverage Means Risk
  • Combined or Total Leverage
what is leverage
What is Leverage?
  • Use of special forces and effects to magnify or produce more than the normal results from a given course of action
  • Leverage involves using fixed costs to magnify the potential return to a firm
    • Can produce beneficial results in favorable conditions
    • Can produce highly negative results in unfavorable conditions
leverage in a business
Leverage in a Business
  • Determining type of fixed operational costs
    • Plant and equipment
      • Can reduce expensive labor in production of inventory
    • Expensive labor
      • Lessens opportunity for profit but reduces risk exposure
  • Determining type of fixed financial costs
    • Debt financing
      • Can produce substantial profits, but failure to meet contractual obligations can result in bankruptcy
    • Selling equity
      • May reduce potential profits for existing shareholders, but reduces their risk exposure
break even be point
Break-Even (BE) Point
  • Quantity where Total Revenue equals Total Cost
  • Company has no Profit or Loss
  • BE = FC / (P – VC)
  • A leveraged firm has a high BE point
  • A non-leveraged firm has a low BE point
slide6

FIGURE 5-1

Break-even chart:Leveraged firm

slide7

FIGURE 5-2

Break-even chart:Conservative firm

slide8

TABLE 5-2

Volume-cost-profit analysis:Leveraged firm

slide9

TABLE 5-3

Volume-cost-profit analysis:Conservative firm

slide10

FIGURE 5-3

Nonlinear break-evenanalysis

operating leverage
Operating Leverage
  • Measure of the amount of fixed operating costs used by a firm.
  • Degree of Operating Leverage (DOL) = % in EBIT (or Operating Income) / %  in Sales

DOL = Q(P-VC) / (Q(P-VC) –FC)

  • Operating Leverage measures the sensitivity of a firm’s operating income to a  in sales.
slide12

TABLE 5-4

Operating income orloss

financial leverage
Financial Leverage
  • Measure of the amount of debt used by a firm
  • Degree of Financial Leverage (DFL) = % in EPS / %  in EBIT (or Operating Income)
  • DFL = EBIT / (EBIT –I)
  • Financial Leverage measures the sensitivity of a firm’s earnings per share to a  in operating income
leverage means risk
Leverage Means Risk
  • Leverage is a double-edged sword
  • It magnifies profits as well as losses
  • An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point)
  • A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)
  • Many Japanese firms tend to be highly leveraged
slide15

FIGURE 5-4

Financing plans andearnings per share

slide16

TABLE 5-5

Impact of financingplan on earningsper share

financial leverage17
Financial Leverage
  • Reflects the amount of debt used in the capital structure of the firm
    • Determines how the operation is to be financed
    • Determines the performance between two firms having equal operating capabilities

BALANCE SHEET

Assets Liabilities and Net Worth

Operating leverage Financial leverage

slide18

TABLE 5-6

Income statement

combined or total leverage
Combined or Total Leverage
  • Represents maximum use of leverage
  • Degree of Combined or Total Leverage (DCL or DTL) = % in EPS / % in Sales
  • DCL= Q(P-VC)/(Q(P-VC)-FC-I)

= (S-TVC) /( S-TVC –FC- I)

  • Short-cut formula:

DCL or DTL = DOL x DFL

slide20

TABLE 5-7

Operating andfinancial leverage

combining operating and financial leverage
Combining Operating and Financial Leverage
  • Combined leverage: when both leverages allow a firm to maximize returns
    • Operating leverage:
      • Affects the asset structure of the firm
      • Determines the return from operations
    • Financial leverage:
      • Affects the debt-equity mix
      • Determines how the benefits received will be allocated