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What is Leverage?
2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firms business risk. 2) Financial Leverage - affects a firms financial risk.
Business Risk
EBIT
FIRM
EPS
Stockholders
Business Risk
Affected by: Sales volume variability Competition Cost variability Product diversification Product demand Operating 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.
EBIT
Operating Leverage
Financial Risk
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
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.
FIRM EPS Stockholders
EBIT
Financial Leverage
The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).
EPS
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.
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
} EBIT
FC {
Breakeven point
Q1
Quantity
Operating Leverage
What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?
Total Revenue
Total Cost
} EBIT
FC {
Breakeven point
Q1
Quantity
Total Revenue
+
FC
}
Q1
EBIT
Total Cost = Fixed
Breakeven point
Quantity
With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Total Revenue
+
FC
}
Q1
EBIT
Total Cost = Fixed
Breakeven point
Quantity
FC
Breakeven point
the firm has a higher breakeven EBIT point. If sales are not + high enough, the firm will not meet its fixed Total Cost expenses! = Fixed
Q1
Quantity
Breakeven Calculations
Breakeven Calculations
Breakeven point (units of output)
QB =
F P-V
Breakeven Calculations
Breakeven point (units of output)
QB =
F P-V
QB = breakeven level of Q. F = total anticipated fixed costs. P = sales price per unit. V = variable cost per unit.
Breakeven Calculations
Breakeven point (sales dollars)
S* =
F VC 1S
Breakeven Calculations
Breakeven point (sales dollars)
S* =
F VC 1S
S* = breakeven level of sales. F = total anticipated fixed costs. S = total sales. VC = total variable costs.
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.
DOLs =
DOLs =
% change in EBIT % change in sales change in EBIT EBIT change in sales sales
Q(P - V) Q(P - V) - F
If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share.
If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
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.
DCL =
DCL =
Q(P - V) Q(P - V) - F - I
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
In-class Project:
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
Sales (100,000 units) Variable Costs Fixed Costs Interest paid Tax rate Common shares outstanding $1,400,000 $800,000 $250,000 $125,000 34% 100,000
Leverage Sales
DCL DOL
EPS
DFL
EBIT
EPS
DFL
EBIT
EPS
DFL =
EBIT
350,000 225,000
EPS
DFL = 1.556
EBIT
DCL =
DCL =
DCL =
EPS
DFL = 1.556
EBIT
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%)