Financial LeverageOperating Leverage 1.

Break-Even and Leverage

2. What is Leverage?
3. What is Leverage?
4. What is Leverage?
5. 2 more concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firms business risk. 2)
Financial Leverage - affects a firms financial risk.
6. The variability or uncertainty of a firms operating income (EBIT).Business Risk
7. The variability or uncertainty of a firms operating income (EBIT). EBITBusiness Risk
8. The variability or uncertainty of a firms operating income (EBIT). EBIT FIRMBusiness Risk
9. The variability or uncertainty of a firms operating income (EBIT). EBIT FIRM EPSBusiness Risk
10. The variability or uncertainty of a firms operating income (EBIT). EBIT FIRM EPS Stock-holdersBusiness Risk
11. The variability or uncertainty of a firms operating income (EBIT). EBIT FIRM EPS Stock-holdersBusiness Risk
12. Operating Leverage. Product demand Product diversification, Cost variability, Competition, Sales volume
variability, Business Risk Affected by:
13. A firm with relatively high fixed operating costs will experience more variable operating income if sales change. The
use of fixed operating costs as opposed to variable operating costs. Operating Leverage
14. EBIT Operating Leverage
15. The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that
arises when a firm uses financial leverage.Financial Risk
16. The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that
arises when a firm uses financial leverage. EBIT FIRM EPS Stock-holdersFinancial Risk
17. The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that
arises when a firm uses financial leverage. EBIT FIRM EPS Stock-holdersFinancial Risk
18. The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common
stock).Financial Leverage
19. EPS Financial Leverage
20. Quantity $ Breakeven Analysis
21. Quantity $ Total Revenue
22. Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable
operating costs (materials, labor, energy, packaging, sales commissions).Costs
23. Quantity { $ Total Revenue Total Cost FC
24. Quantity { $ Total Revenue Total Cost FC Break-even point }EBIT Q1 + 25. What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?Operating
Leverage
26. Quantity $ { Total Revenue Total Cost FC = Fixed Break-even point } Q1 + - EBIT
27. With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
28. Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed Quantity $
{ Total Revenue Total Cost FC = Fixed Break-even point } Q1 + - EBIT expenses!
29. Breakeven Calculations Breakeven point (units of output) QB = FC p v
30. V = variable cost per unit. P = sales price per unit. F = total anticipated fixed costs. QB = breakeven level of Q.
Breakeven Calculations Breakeven point (units of output) QB = FC p - v
31. Breakeven Calculations Breakeven point (sales dollars) S* = F VC S 1 32. VC = total variable costs. S = total sales. F = total anticipated fixed costs. S* = breakeven level of sales.
Breakeven Calculations Breakeven point (sales dollars) S* = F VC S 1 33. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income
34. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income }
contribution margin
35. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income
EBT (1 - t) = Net Income, so, Net Income / (1 - t) = EBT
36. This multiplier effect is called the degree of operating leverage. Operating leverage: by using fixed operating costs,
a small change in sales revenue is magnified into a larger change in operating income. Degree of Operating Leverage
(DOL)
37. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales
38. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT
EBIT change in sales sales =

39. If we have the data, we can use this formula: DOLs = from Sales Level (S) Sales - Variable Costs EBITDegree of
Operating Leverage
40. If we have the data, we can use this formula: SaDegree of Operating Leverage DOLs = from Sales Level (S) les Variable Costs EBIT Q(p - v) Q(p - v) - FC =
41. If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).What does this tell
us?
42. If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- EBIT holders
Sales EPSWhat does this tell us?
43. This multiplier effect is called the degree of financial leverage. Financial leverage: by using fixed cost financing, a
small change in operating income is magnified into a larger change in earnings per share. Degree of Financial Leverage
(DFL)
44. Degree of Financial Leverage DFL = % change in EPS % change in EBIT
45. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
46. If we have the data, we can use this formula: DFL = EBIT EBIT - IDegree of Financial Leverage
47. 1 DFL in case where there is preferred stock PD T EBIT EBIT I DFL
48. If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.What does this
tell us?
49. If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- EBIT
holders Sales EPSWhat does this tell us?
50. This multiplier effect is called the degree of combined leverage. Combined leverage: by using operating leverage
and financial leverage, a small change in sales is magnified into a larger change in earnings per share. Degree of
Combined Leverage (DCL)
51. Degree of Combined Leverage DCL = DOL x DFL % change in EPS % change in Sales = change in EPS EPS change
in Sales Sales =
52. If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - IDegree of Combined Leverage
53. If we have the data, we can use tDegree of Combined Leverage his formula: DCL = Sales - Variable Costs EBIT - I
Q(p - v) Q(p - v) - FC - I =
54. 1 DCL where there is preferred stock Sales VariableCost PD T EBIT I DFL
55. If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.What does this tell us?
56. If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- EBIT holders Sales
EPSWhat does this tell us?
57. 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?Team Project:
58. 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
59. Leverage Sales DOL EPS EBIT DFL DCL
60. Levered Company Sales DOL = EPS EBIT DFL DCL
61. Levered Company Sales DOL = 1.714 EPS EBIT DFL = DCL
62. Levered Company Sales DOL = 1.714 EPS EBIT DFL = 1.556 DCL
63. Levered Company Sales DOL = 1.714 DCL = 2.667 EPS EBIT DFL = 1.556
64. Levered Company 10% 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%)
65. What is the impact of the proposed restructuring ? Assume that stock price will remain $20 New Debt equity ratio =
1 New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares, leaving 2,00,000 Proposed debt issue
would raise $ 4,000,000, interest rate = 10 % When all equity firm, price per share = $ 20 Shares outstanding =
400,000 Firms market value = $ 8,000,000 CFO is considering a restructuring that would involve issuing debt and
using the proceeds to buy back some of the outstanding equity. The more debt financing a firm uses in its capital
structure, the more financial leverage it employs. Illustration: The effect of financial leverage
66. Illustration (contd) Current Capital Structure: No debt Recession Expected Expansion EBIT $ 5,00,000 $ 1,000,000
$ 1,500,000 Interest 0 0 0 Net Income $ 5,00,000 $ 1,000,000 $ 1,500,000 ROE 6.25 % 12.50 % 18.75 % EPS $ 1.25 $
2.50 $ 3.75 Proposed Capital Structure: Debt = $ 4,000,000 EBIT $ 500,000 $ 1,000,000 $ 1,500,000 Interest 400,000
400,000 400,000 Net Income $ 100,000 $ 600,000 $ 1,100,000 ROE 2.50 % 15.00 % 27.50 % EPS $ 0.50 $ 3.00 $ 5.50

67. Illustration (contd) In no debt case, every $ 400,000 increase in EBIT increases EPS by $ 1 In proposed capital
structure, every $ 400,000 increase in EBIT increases EPS by $ 2 Breakeven point is indifference point. If EBIT is above
this level, leverage is beneficial, otherwise not.