Transcript Ch05

Chapter
5
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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 management’s attitude
toward risk and the nature of its business, among others.

Three types of leverage with reference to the firm’s income statement:
 Operating leverage,
 Financial leverage, and
 Combined (Total) leverage.

Leverage is measured on the profitability range of operations.
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
Breakeven Analysis
Plan A (Leveraged)
Plan B (Less LeveragedConservative)
Selling Price (/unit) = $2.00
Fixed Cost = $60,000
Fixed Cost = $12,000
Variable Cost (/unit) = $0.80
Variable Cost (/unit) = $1.60
Contribution Margin(/unit) = $1.20
Contribution Margin(/unit) = $0.40
Break-Even Point (units) = 50,000
Break-Even Point (units) = 30,000
© 2003 McGraw-Hill Ryerson Limited
PPT 5-4
Figure 5-1
Break-even chart: leveraged firm
Total
Revenue
Revenues and costs ($ thousands)
200
Profit
160
Total
costs
BE
120
100
80
60
Variable costs
Loss
Fixed
costs
40
20
Price ($2)
Variable costs per unit ($0.80)
Fixed costs ($60,000)
40 50 60
80
100
Units produced and sold (thousands)
120
© 2003 McGraw-Hill Ryerson Limited
PPT 5-5
Table 5-2
Volume-cost-profit analysis: Leveraged
firm
Units
Sold
Total
Variable
Costs
Fixed
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
$60,000
60,000
60,000
60,000
60,000
60,000
60,000
Total
Costs
Operating
Total
Income
Revenue
(loss)
$ 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
$(60,000)
(36,000)
(12,000)
0
12,000
36,000
60,000
© 2003 McGraw-Hill Ryerson Limited
PPT 5-6
Figure 5-2
Break-even chart: conservative firm
Total
Revenue
Revenues and costs ($ thousands)
200
Profit
Total
costs
160
120
80
BE
Variable costs
40
Loss
20
40
60
80
100
Fixed
costs
120
Units produced and sold (thousands)
Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)
© 2003 McGraw-Hill Ryerson Limited
PPT 5-7
Table 5-3
Volume-cost-profit analysis: Less
Leveraged (Conservative) firm
Units
Sold
Total
Variable
Costs
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
Total
Revenue
Operating
Income
(loss)
$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
Fixed
Costs
Total
Costs
.
.
© 2003 McGraw-Hill Ryerson Limited
PPT 5-10
Table 5-4
Operating income or loss
Leveraged
Plan
Units
EBIT
0
20,000
30,000
40,000
50,000
60,000
80,000
100,000
$(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
© 2003 McGraw-Hill Ryerson Limited
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)
 A conservative
or less-leveraged firm has a relatively
low break-even point (and low fixed costs)
© 2003 McGraw-Hill Ryerson Limited
PPT 5-9
Operating Leverage
 Measures
the amount of fixed operating costs used
by a firm
 Operating Leverage measures the sensitivity of a
firm’s 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
© 2003 McGraw-Hill Ryerson Limited
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
or
DOL 
CM
EBIT
© 2003 McGraw-Hill Ryerson Limited
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
firm’s 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)
© 2003 McGraw-Hill Ryerson Limited
Calculating the Degree of Financial
Leverage
DFL
can be computed using the following formula:
EBIT
DFL 
EBIT  I
© 2003 McGraw-Hill Ryerson Limited
Financing Plans
Total Assets = $200,000
Plan A (Leveraged)
Plan B (Less
LeveragedConservative)
Debt (8%)
$150,000 ($12,000
interest)
$50,000 ($4,000
interest)
Common Stock
$50,000 (8,000 shares @ $150,000 (24,000 shares
$6.25)
@ $6.25)
Total Financing
$200,000
$200,000
© 2003 McGraw-Hill Ryerson Limited
PPT 5-13
Table 5-5a
Impact of financing plan on earnings per
share
Plan A
(leveraged)
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)
Plan B
(conservative)
0
$(12,000.)
(12,000.)
(6,000.)
$ (6,000.)
8,000
$ (0.75)
0
$ (4,000.)
(4,000.)
(2,000.)
$ (2,000.)
24,000
$ (0.08)
$12,000
12,000
0
0
$
0
8,000
0
$12,000
4,000
8,000
4,000
$ 4,000
24,000
$0.17
* 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.
© 2003 McGraw-Hill Ryerson Limited
PPT 5-14
Table 5-5b
Impact of financing plan on earnings per
share
Plan A
(leveraged)
Plan B
(conservative)
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)
$ 16,000
12,000
4,000
2,000
$ 2,000
8,000
$0.25
$ 16,000
4,000
12,000
6,000
$ 6,000
24,000
$0.25
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)
$ 36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
$ 36,000
4,000
32,000
16,000
$ 16,000
24,000
$0.67
© 2003 McGraw-Hill Ryerson Limited
PPT 5-15
Table 5-5c
Impact of financing plan on earnings per
share
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)
Plan A
(leveraged)
Plan B
(conservative)
$ 60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
$ 60,000
4,000
56,000
28,000
$ 28,000
24,000
$ 1.17
© 2003 McGraw-Hill Ryerson Limited
PPT 5-10
EBIT and EPS under both plans
Leveraged
Plan
EBIT
EPS
0
12,000
16,000
36,000
60,000
$ (0.75)
0
$0.25
$1.50
$3.00
Less Leveraged
(Conservative)
Plan
EPS
$ (0.08)
$0.17
$0.25
$0.67
$ 1.17
© 2003 McGraw-Hill Ryerson Limited
PPT 5-16
Figure 5-4
Financing plans and earnings per share
EPS ($)
4
Plan A
3
Plan B
2
1
.25
0
-1
-2
0
12
25
16
50
75
100
EBIT ($ thousands)
© 2003 McGraw-Hill Ryerson Limited
PPT 5-19
Combined or Total Leverage
 Represents
a
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
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
© 2003 McGraw-Hill Ryerson Limited
Calculating EBIT at Indifference Point
Level of EBIT where the firm’s 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
© 2003 McGraw-Hill Ryerson Limited
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))
© 2003 McGraw-Hill Ryerson Limited