Chapter 15 – Analysis and Impact of Leverage

1. Chapter 15 – Analysis and Impact of Leverage

2. What is Leverage • Company A: sales increases 2.9 percent, but net income increases 16.9 percent. • Company B: sales decreases 3.6 percent, but net income decreases 19.4 percent.

3. Two 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.

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

5. Business Risk Affected by: • Sales volume variability • Competition • Product diversification • Operating leverage • Growth prospects • Size

6. 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.

7. 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.

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

9. 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.

10. 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).

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

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

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

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

15. 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.

16. 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.

17. 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.

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

19. 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:

20. Stock- holders EPS EBIT Sales What does this tell us? • If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).

21. 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. • This “multiplier effect” is called the degree of financial leverage.

22. Degree of Financial Leverage % change in EPS % change in EBIT DFL = change in EPS EPS change in EBIT EBIT =

23. EBIT EBIT - I DFL = Degree of Financial Leverage • If we have the data, we can use this formula:

24. Stock- holders EPS EBIT Sales What does this tell us? • If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.

25. 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.

26. % change in EPS % change in Sales = change in EPS EPS change in Sales Sales = Degree of Combined Leverage DCL = DOL x DFL

27. Sales - Variable Costs EBIT - I DCL = Q(P - V) Q(P - V) - F - I = Degree of Combined Leverage • If we have the data, we can use this formula:

28. Stock- holders EPS EBIT Sales What does this tell us? • If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.

29. In-class Project: Based on the following information on 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?

30. Levered Company Sales (100,000 units) $1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Common shares outstanding 100,000

31. Sales Operating Income EPS Operating leverage Financial leverage Levered Company

32. Sales - Variable Costs EBIT DOLs = 1,400,000 - 800,000 350,000 = 1.714 = Degree of Operating Leverage from Sales Level (S)

33. 10% 17.14% Sales Operating Income EPS Operating leverage Levered Company

34. EBIT EBIT - I 350,000 225,000 = 1.556 DFL = = Degree of Financial Leverage

35. 10% 15.56% Sales Operating Income EPS Financial leverage Levered Company

36. Sales - Variable Costs EBIT - I DCL = 1,400,000 - 800,000 225,000 = 2.667 = Degree of Combined Leverage

37. 10% 26.67% Sales Operating Income EPS Operating leverage Financial leverage Levered Company

38. 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%)