Chapter

Operating and Financial Leverage

Prepared by: Terry Fegarty Seneca College Revised By P Chua

McGraw-Hill Ryerson

2003 McGraw-Hill RyersonLimited Limited 2003 McGraw-Hill Ryerson

PPT 5-2

Chapter 5 - Outline
What

is Leverage? Break-even Analysis Operating Leverage Financial Leverage Combined or Total Leverage Summary and Conclusions

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PPT 5-3

What is Leverage?

In general terms, leverage means the use of force and effects to produce a more than normal results from a given action In other words, leverage is the advantage generated by using a lever

Example, using a jack to lift a car

In Finance, leverage is the use of fixed costs to magnify the potential return to a firm 2 types of fixed costs: fixed operating costs = rent, salaries, etc. fixed financial costs = interest costs from debt
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What is Leverage?

Leverage can magnify returns to common stockholders but can also increase risk Management has almost complete control over this risk introduced through the use of leverage (fixed costs)

The degree in the use of leverage depends on managements attitude toward risk and the nature of its business, among others.
Three types of leverage with reference to the firms income statement: Operating leverage, Financial leverage, and Combined (Total) leverage. Leverage is measured on the profitability range of operations.
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What is Leverage?
Sales Less: Cost of Goods Sold Gross Margin Less: Operating Expenses Earnings Before Interest and Taxes (EBIT) Less: Interest Earnings Before Taxes Less: Taxes Earnings After Taxes (EAT) Number of Shares Outstanding Earnings Per Share

Operating leverage

Financial leverage

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What is Leverage?
Sales Less: Total variable Costs Contribution Margin Less: Fixed Cost Earnings Before Interest and Taxes (EBIT) Less: Interest Earnings Before Taxes Less: Taxes Earnings After Taxes (EAT) Number of Shares Outstanding Earnings Per Share

Operating leverage

Financial leverage

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Breakeven Analysis

Break-even Analysis is used by the firm: To determine the level of operations necessary to cover all operating costs, and To evaluate the profitability associated with various levels of sales. The Operating Breakeven Point is the level of sales necessary to cover all operating costs. The formula for determining operating breakeven is: EBIT = (P Q) (VC Q) FC (1) where P = sales price per unit Q = sales quantity in units FC = fixed operating cost per period VC = variable operating cost per unit EBIT = earnings before interest and taxes
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Breakeven Quantity

Equation (1) can be rewritten to solve for the sales quantity that will breakeven: (2)

FC Q P VC

Since P VC is the Contribution Margin per unit (CM/unit), equation 2 becomes:

(3)

FC Q CM / unit
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Breakeven Analysis

Plan A (Leveraged)

Plan B (Less LeveragedConservative)

Selling Price (/unit) = $2.00

Fixed Cost = $60,000

Variable Cost (/unit) = $0.80 Contribution Margin(/unit) = $1.20

Fixed Cost = $12,000

Variable Cost (/unit) = $1.60 Contribution Margin(/unit) = $0.40

Break-Even Point (units) = 50,000

Break-Even Point (units) = 30,000

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PPT 5-4

Figure 5-1

Break-even chart: leveraged firm

Revenues and costs ($ thousands)
200

Total Revenue

Profit
160

120 100 80

BE

Total costs

Variable costs Loss

60
40

Fixed costs
40 50 60 80 100 120

20
Price ($2) Variable costs per unit ($0.80) Fixed costs ($60,000)

Units produced and sold (thousands)

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Table 5-2

PPT 5-5

Volume-cost-profit analysis: Leveraged firm

Total Units Variable Sold Costs 0 20,000 40,000 50,000 60,000 80,000 100,000 0 16,000 32,000 40,000 48,000 64,000 80,000

Fixed Costs
$60,000 60,000 60,000 60,000 60,000 60,000 60,000

Total Costs

Operating Total Income Revenue (loss) $(60,000) (36,000) (12,000) 0 12,000 36,000 60,000

$ 60,000 0 76,000 $ 40,000 92,000 80,000 100,000 100,000 108,000 120,000 124,000 160,000 140,000 200,000

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PPT 5-6

Figure 5-2

Break-even chart: conservative firm

Revenues and costs ($ thousands) 200
160 120 80 40 Loss Fixed costs 120 BE Variable costs Total Revenue Profit Total costs

Units produced and sold (thousands) Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)

20

40

60

80

100

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Table 5-3

PPT 5-7

Volume-cost-profit analysis: Less Leveraged (Conservative) firm

Units Sold

Total Variable Costs

Fixed Costs

Total Costs

Total Revenue

Operating Income (loss)

0 0 20,000 $ 32,000 30,000 48,000 40,000 64,000 60,000 96,000 80,000 128,000 100,000 160,000

$12,000 $ 12,000 0 12,000 44,000 $ 40,000 12,000 60,000 60,000 12,000 76,000 80,000 12,000 108,000 120,000 12,000 140,000 160,000 12,000 172,000 200,000

$(12,000) (4,000) 0 4,000 12,000 20,000 28,000

. .

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PPT 5-10

Table 5-4

Operating income or loss

Leveraged Plan Units 0 20,000 30,000 40,000 50,000 60,000 80,000 100,000 EBIT $(60,000) (36,000) (12,000) (12,000) 0 12,000 36,000 60,000 Less Leveraged (Conservative) Plan EBIT $(12,000) (4,000) 0 4,000 8,000 12,000 20,000 28,000

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PPT 5-8

Leverage Means Risk

Leverage

is a double-edged sword It magnifies losses as well as profits

An

aggressive or highly leveraged firm has a relatively high break-even point (and high fixed costs)

conservative or less-leveraged firm has a relatively low break-even point (and low fixed costs)
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PPT 5-9

Operating Leverage
Measures

the amount of fixed operating costs used

by a firm Operating Leverage measures the sensitivity of a firms operating income to a in sales a in Sales a larger in EBIT (or OI)
Degree of Operating Leverage (DOL)= %age in EBIT ( or OI) %age in Sales
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Calculating the Degree of Operating Leverage

DOL

can be computed using the following formula:

Q( P VC ) DOL Q( P VC ) FC

or

S TVC DOL S TVC FC CM DOL EBIT

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or

PPT 5-12

Financial Leverage
Measure

of the amount of debt used and interest paid by a firm Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income a in EBIT (or OI) a larger in EPS Degree of Financial Leverage (DFL) = %age in EPS %age in EBIT (or OI)
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Calculating the Degree of Financial Leverage

DFL

can be computed using the following formula:

EBIT DFL EBIT I

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Financing Plans

Total Assets = $200,000

Plan A (Leveraged) Plan B (Less LeveragedConservative) $50,000 ($4,000 interest)

Debt (8%) Common Stock

$150,000 ($12,000 interest)

$50,000 (8,000 shares @ $150,000 (24,000 shares $6.25) @ $6.25)

Total Financing

$200,000

$200,000

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Table 5-5a

PPT 5-13

Impact of financing plan on earnings per share

Plan A (leveraged) Plan B (conservative) 0 $ (4,000.) (4,000.) (2,000.) $ (2,000.) 24,000 $ (0.08) $12,000 4,000 8,000 4,000 $ 4,000 24,000 $0.17 1. EBIT (0) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) * Earnings aftertaxes(EAT) Shares Earnings per share (EPS) 2. EBIT ($12,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings aftertaxes (EAT) Shares Earnings per share (EPS) 0 $(12,000.) (12,000.) (6,000.) $ (6,000.) 8,000 $ (0.75) $12,000 12,000 0 0 $ 0 8,000 0

* The assumption is that large losses can be written off against other income, perhaps in other years, thus providing the firm with a tax savings benefit. The tax rate is 50 percent.
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Table 5-5b

PPT 5-14

Impact of financing plan on earnings per share

Plan A (leveraged) 3. EBIT ($16,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings aftertaxes (EAT) Shares Earnings per share (EPS) 4. EBIT ($36,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings aftertaxes (EAT) Shares Earnings per share (EPS) $ 16,000 12,000 4,000 2,000 $ 2,000 8,000 $0.25 $ 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50 Plan B (conservative) $ 16,000 4,000 12,000 6,000 $ 6,000 24,000 $0.25 $ 36,000 4,000 32,000 16,000 $ 16,000 24,000 $0.67
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Table 5-5c

PPT 5-15

Impact of financing plan on earnings per share

Plan A (leveraged) 5. EBIT ($60,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings aftertaxes (EAT) Shares Earnings per share (EPS) $ 60,000 12,000 48,000 24,000 $ 24,000 8,000 $3.00 Plan B (conservative) $ 60,000 4,000 56,000 28,000 $ 28,000 24,000 $ 1.17

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PPT 5-10

EBIT and EPS under both plans

Leveraged Plan EBIT EPS Less Leveraged (Conservative) Plan EPS

0 12,000 16,000 36,000 60,000

$ (0.75) 0 $0.25 $1.50 $3.00

$ (0.08) $0.17 $0.25 $0.67 $ 1.17

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PPT 5-16

Figure 5-4

Financing plans and earnings per share

EPS ($) 4 3 Plan B 2 1 .25 0 -1 -2 0 12 25 16 50 75 100 EBIT ($ thousands)
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Plan A

PPT 5-19

Combined or Total Leverage

Represents

maximum use of leverage

in Sales a larger in EPS

Degree of Combined Leverage (DCL ) = %age in EPS %age in Sales

Short-cut formula:
DCL = DOL x DFL
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Calculating the Degree of Combined Leverage

DCL

can be computed using the following formula:

Q( P VC ) DCL Q( P VC ) FC I

OR
S TVC DCL S TVC FC I

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PPT 5-18

Operating, Financial and Combined Leverage under Leveraged Plan

Sales (80,000 units @ $2) Less: Variable costs ($0.80 per unit) Contribution Margin Less: Fixed costs Earnings before interest and taxes Less:Interest Earnings before taxes Less:Taxes Earnings aftertaxes Shares Earnings per share

$160,000 64,000 96,000 60,000 $ 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50

Operating Leverage = 2.67

Financial Leverage = 1.5

Combined Leverage= 4

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PPT 5-18

Operating, Financial and Combined Leverage under Less Leveraged (Conservative) Plan

Sales (80,000 units @ $2) Less: Variable costs ($1.60 per unit) Contribution Margin Less: Fixed costs Earnings before interest and taxes Less:Interest Earnings before taxes Less:Taxes Earnings aftertaxes Shares Earnings per share

$160,000 128,000 32,000 12,000 $ 20,000 4,000 16,000 8,000 $ 8,000 24,000 $0.33

Operating Leverage = 1.6

Financial Leverage = 1.25

Combined Leverage= 2

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Calculating EBIT at Indifference Point

Level of EBIT where the firms EPS are equal between 2 financing plans
This

is computed using the following formula:

( SB * IA SA * IB ) EBIT SB SA
Where: EBIT is the operating income at the indifference point I is the interest cost under plan A and B S is shares outstanding under plan A and B
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PPT 5-22

Summary and Conclusions

Leverage uses fixed costs to magnify the profits (or losses) of a business Operating leverage refers to fixed operating costs, such as lease or amortization expense The degree of operating leverage (DOL) measures the %age change in operating income from a %age change in sales Financial leverage refers to interest expense on debt The degree of financial leverage (DFL) measures the %age change in earnings from a %age change in operating income The higher the level of fixed costs, the greater the effect on net income of an increase in sales revenue (This is the degree of combined leverage (DCL))
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