Operating Leverage Financial Leverage

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

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

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

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

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

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. Stock- holders FIRM EPS EBIT 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.

18. Stock- holders FIRM EPS EBIT 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.

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.

23. $ Quantity Breakeven Analysis

24. Total Revenue $ Quantity

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. Total Revenue $ Quantity

27. Total Revenue Total Cost $ { FC Quantity

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

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

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

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

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

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

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

35. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point 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. F P - V QB = Breakeven Calculations Breakeven point (units of output)

38. F P - V QB = 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.

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

40. F VC S S* = 1 - Breakeven Calculations Breakeven point (sales dollars) • S* = breakeven level of sales. • F = total anticipated fixed costs. • S = total sales. • VC = total variable costs.

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

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

43. Analytical Income Statement } contribution margin sales - variable costs - fixed costs operating income - interest EBT - taxes net income 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 Leveragefrom Sales Level (S) % change in EBIT % change in sales DOLs =

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

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

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

49. Sales - Variable Costs EBIT DOLs = Q(P - V) Q(P - V) - F = Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula:

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).