Financial Leverage

Financial leverage refers to the advantage derived from use of borrowed capital to magnify the effects of
changes in earnings before interest and income taxes (EBIT) on the firms earnings per share (EPS).
Example: XYYZ Corp. realizes income of P80, 000 before interest and income taxes and its balance sheet
shows the ff.
Assets
.. P500, 000
Liabilities ....... 200, 000
Stockholders equity .. 300, 000
Outstanding shares

..

2, 000 (parvalue-P100)

The company is reviewing an expansion proposal requiring additional capital of P250, 000 so as to increase
its operating income by P100, 000. Two alternatives have been presented:
a. Obtain a P250, 000 loan with interest of 20%.
b. Issue additional 1, 250 shares of capital stock at the market price of P200 per share.
Income tax rate is 35%.
The financial projections under the two alternatives would be as follows:
(b)
Income before interest and income taxes
Less: Interest expenses
Income before income taxes
Less: Income taxes, 35%
Net income

P180, 000
50, 000
P130, 000
45, 500
P84, 500

Rate of return on owners equity:

P84, 500/P300, 000
P177, 000/ (P300, 000 + 250, 000)

28%

Earnings per share:

P84, 500/2, 000 shares
P117, 000/ (2, 000+ 1, 250 shares)

P45.25

P180, 000
P180, 000
63, 000
P117, 000

21%

P36.00

Cost-Volume-Profit (CVP) Analysis

Breakeven Point the level of activity (production and sales) at which the company would be able to avoid a loss
(

Contribution margin - the difference between unit selling price and unit variable costs and expenses or total sales
and total variable costs and expenses
Contribution margin percentage is the ratio of unit contribution margin to unit selling price or the total
contribution margin to total sales.

Example: Fixed costs and expenses amount P80, 000. Unit selling price is P40 and unit variable cost and
expenses amount to P30. Relevant range is from 0 20, 000 units.
Unit price
Unit variable cost and expenses
Contribution margin per unit
The computations are as follows:
Unit selling
price of P40

P40
30
10

100%
75%
25%

Contribution Margin
per Unit

Contribution Margin
Percentage*

Contribution Margin
per Unit of P10

Breakeven Point
Sales Volume

Fixed Cost (and Expenses) of P80, 000

Unit Contribution Margin of P10

= 8, 000 units

Breakeven Point
Peso Sales

Fixed Cost (and Expenses) of P80, 000

Contribution Margin %, 25%

= P320, 000

Unit variable costs

and expenses of P30

= P10

Unit selling
price of P40

= 25%

*or P/V (profit/volume) ratio

Breakeven Chart
The breakeven (or cost-volume-profit) graph is prepared as follows:

Pinpoint on the graph the ff. figures based on the highest production/sales level within the
relevant range: revenue (R), total cost and expenses (TC), fixed cost and expenses (FC).
Draw the R, TC, FC lines.
Determine at what point the R and TC lines intersect. (The point of intersection must be the
breakeven point)

Revenue (20, 000 x P40)

Cost and expenses:
Variable (20, 000 x P30)
Fixed
Total costs and expenses
Net income
The breakeven chart is as follows:

P800, 000
P600, 000
P80, 000
680, 000
P120, 000

The BEP (or CVP) chart shows the behavior of revenue, costs and expenses. Production/sales volumes to
the left of the breakeven point are expected to result in a loss while to the right are expected to result in profit.
Use of Budget in Analyzing Financial Statements
Budget a formal statement of a planned course of action expressed in quantitative terms, often
prepared for one year in advance with separate budget estimates for each month or for each year
Budgetary control the use of budget and budgetary reports to coordinate, evaluate and control day-today operators in accordance with goals specified by budgets

Present Value of Annuity Due

(