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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**• 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**• 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**• 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 ($)**Total Revenue**(PQ) $ Quantity Breakeven Analysis**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)**Total Revenue**Total Cost (QV)+F or VC+F $ { FC Quantity Breakeven Analysis } + EBIT - Q1 Breakeven EBIT**Operating Leverage**• What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?**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**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)**• 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 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 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)**• 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**• Each financing or capital structure (relative use of debt and equity) alternative will have a different degree of financial leverage (DFL)**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)**• 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**• 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**• 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**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 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 (S)**• Answer to part 1: • %Δ in EBIT = DOLSales x %Δ in Sales • %Δ in EBIT = 1.714 x 10% = 17.14%**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 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%**Sales**DCL = 2.667 DOL = 1.714 EPS EBIT DFL = 1.556 Levered Company**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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