Analysis And Impact Of Leverage
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Chapter 15 – Analysis and Impact of Leverage
Operating Leverage Financial Leverage
What is Leverage?
What is Leverage?
What is Leverage?
Two concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
Business Risk Affected by: Sales volume variability Competition Product diversification Operating leverage Growth prospects Size
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 firm’s 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 firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT
FIRM
EPS
Stockholders
Financial Risk
The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT
FIRM
EPS
Stockholders
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.
Breakeven Analysis $
Quantity
Total Revenue
$
Quantity
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
$
Quantity
Total Revenue
$
Total Cost
FC { Quantity
Total Revenue
Total Cost
$
+
} EBIT
FC { Q1
Quantity
Total Revenue
Total Cost
$
+
} EBIT
FC { Break-even 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
}
EBIT Total Cost = Fixed
Break-even point
Q1
Quantity
With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Total Revenue
$
+
{
FC
}
EBIT
Breakeven point
Q1
Total Cost = Fixed Quantity
Total Revenue Trade-off:
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
$
{
FC
}
Breakeven point
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.
Analytical Income Statement -
sales variable costs fixed costs operating income interest EBT taxes net income
Degree of Operating Leverage (DOL)
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.
Degree of Operating Leverage from Sales Level (S)
DOLs =
% change in EBIT % change in sales
Degree of Operating Leverage from Sales Level (S)
DOLs =
=
% change in EBIT % change in sales change in EBIT EBIT change in sales sales
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Sales - Variable Costs DOLs = EBIT
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Sales - Variable Costs DOLs = EBIT =
Q(P - V) Q(P - V) - F
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
Degree of Financial Leverage (DFL)
Financial leverage: by using fixed
cost financing, a small change in operating income is magnified into a larger change in earnings per share.
This “multiplier effect” is called the degree of financial leverage.
Degree of Financial Leverage DFL =
% change in EPS % change in EBIT
Degree of Financial Leverage % change in EPS % change in EBIT
DFL =
=
change in EPS EPS change in EBIT EBIT
Degree of Financial Leverage If we have the data, we can use this formula:
Degree of Financial Leverage If we have the data, we can use this formula:
EBIT DFL = EBIT - I
What does this tell us? 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? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
What does this tell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
Degree of Combined Leverage (DCL)
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.
Degree of Combined Leverage
Degree of Combined Leverage DCL = DOL x DFL
Degree of Combined Leverage DCL = DOL x DFL % change in EPS = % change in Sales
Degree of Combined Leverage DCL = DOL x DFL % change in EPS = % change in Sales
=
change in EPS EPS change in Sales Sales
Degree of Combined Leverage If we have the data, we can use this formula:
Degree of Combined Leverage If we have the data, we can use this formula:
DCL =
Sales - Variable Costs EBIT - I
Degree of Combined Leverage If we have the data, we can use this formula:
DCL =
=
Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I
What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
What does this tell us? 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: 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?
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
Levered Company
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT =
1,400,000 - 800,000 350,000
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT =
1,400,000 - 800,000 350,000 = 1.714
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Operating leverage
EPS
Levered Company 10%
Sales
Operating Income
Operating leverage
EPS
Levered Company 17.14%
10%
Sales
Operating Income
Operating leverage
EPS
Degree of Financial Leverage EBIT DFL = EBIT - I
Degree of Financial Leverage EBIT DFL = EBIT - I =
350,000 225,000
Degree of Financial Leverage EBIT DFL = EBIT - I =
350,000 225,000 = 1.556
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Financial leverage
EPS
Levered Company 10%
Sales
Operating Income
Financial leverage
EPS
Levered Company 15.56%
10%
Sales
Operating Income
Financial leverage
EPS
Levered Company 15.56%
10%
Sales
Operating Income
Financial leverage
EPS
Degree of Combined Leverage DCL =
Sales - Variable Costs EBIT - I
Degree of Combined Leverage DCL = =
Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000
Degree of Combined Leverage DCL = =
Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Operating leverage
EPS
Levered Company
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 26.67%
10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 26.67%
10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 10% increase in sales
Sales (110,000 units) Variable Costs Fixed Costs EBIT Interest EBT Taxes (34%) Net Income EPS
1,540,000 (880,000) (250,000) 410,000 ( +17.14%) (125,000) 285,000 (96,900) 188,100 $1.881 ( +26.67%)
Operating Leverage Financial Leverage
What is Leverage?
What is Leverage?
What is Leverage?
Two concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
Business Risk
The variability or uncertainty of a firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
Business Risk Affected by: Sales volume variability Competition Product diversification Operating leverage Growth prospects Size
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 firm’s 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 firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT
FIRM
EPS
Stockholders
Financial Risk
The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT
FIRM
EPS
Stockholders
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.
Breakeven Analysis $
Quantity
Total Revenue
$
Quantity
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
$
Quantity
Total Revenue
$
Total Cost
FC { Quantity
Total Revenue
Total Cost
$
+
} EBIT
FC { Q1
Quantity
Total Revenue
Total Cost
$
+
} EBIT
FC { Break-even 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
}
EBIT Total Cost = Fixed
Break-even point
Q1
Quantity
With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Total Revenue
$
+
{
FC
}
EBIT
Breakeven point
Q1
Total Cost = Fixed Quantity
Total Revenue Trade-off:
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
$
{
FC
}
Breakeven point
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.
Analytical Income Statement -
sales variable costs fixed costs operating income interest EBT taxes net income
Degree of Operating Leverage (DOL)
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.
Degree of Operating Leverage from Sales Level (S)
DOLs =
% change in EBIT % change in sales
Degree of Operating Leverage from Sales Level (S)
DOLs =
=
% change in EBIT % change in sales change in EBIT EBIT change in sales sales
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Sales - Variable Costs DOLs = EBIT
Degree of Operating Leverage from Sales Level (S)
If we have the data, we can use this formula:
Sales - Variable Costs DOLs = EBIT =
Q(P - V) Q(P - V) - F
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
Sales
EBIT
EPS
Stockholders
Degree of Financial Leverage (DFL)
Financial leverage: by using fixed
cost financing, a small change in operating income is magnified into a larger change in earnings per share.
This “multiplier effect” is called the degree of financial leverage.
Degree of Financial Leverage DFL =
% change in EPS % change in EBIT
Degree of Financial Leverage % change in EPS % change in EBIT
DFL =
=
change in EPS EPS change in EBIT EBIT
Degree of Financial Leverage If we have the data, we can use this formula:
Degree of Financial Leverage If we have the data, we can use this formula:
EBIT DFL = EBIT - I
What does this tell us? 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? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
What does this tell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
Degree of Combined Leverage (DCL)
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.
Degree of Combined Leverage
Degree of Combined Leverage DCL = DOL x DFL
Degree of Combined Leverage DCL = DOL x DFL % change in EPS = % change in Sales
Degree of Combined Leverage DCL = DOL x DFL % change in EPS = % change in Sales
=
change in EPS EPS change in Sales Sales
Degree of Combined Leverage If we have the data, we can use this formula:
Degree of Combined Leverage If we have the data, we can use this formula:
DCL =
Sales - Variable Costs EBIT - I
Degree of Combined Leverage If we have the data, we can use this formula:
DCL =
=
Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I
What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
Sales
EBIT
EPS
Stockholders
What does this tell us? 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: 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?
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
Levered Company
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT =
1,400,000 - 800,000 350,000
Degree of Operating Leverage from Sales Level (S)
Sales - Variable Costs DOLs = EBIT =
1,400,000 - 800,000 350,000 = 1.714
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Operating leverage
EPS
Levered Company 10%
Sales
Operating Income
Operating leverage
EPS
Levered Company 17.14%
10%
Sales
Operating Income
Operating leverage
EPS
Degree of Financial Leverage EBIT DFL = EBIT - I
Degree of Financial Leverage EBIT DFL = EBIT - I =
350,000 225,000
Degree of Financial Leverage EBIT DFL = EBIT - I =
350,000 225,000 = 1.556
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Financial leverage
EPS
Levered Company 10%
Sales
Operating Income
Financial leverage
EPS
Levered Company 15.56%
10%
Sales
Operating Income
Financial leverage
EPS
Levered Company 15.56%
10%
Sales
Operating Income
Financial leverage
EPS
Degree of Combined Leverage DCL =
Sales - Variable Costs EBIT - I
Degree of Combined Leverage DCL = =
Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000
Degree of Combined Leverage DCL = =
Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667
Levered Company
Sales
Operating Income
EPS
Levered Company
Sales
Operating Income
Operating leverage
EPS
Levered Company
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 26.67%
10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 26.67%
10%
Sales
Operating Income
Operating leverage
Financial leverage
EPS
Levered Company 10% increase in sales
Sales (110,000 units) Variable Costs Fixed Costs EBIT Interest EBT Taxes (34%) Net Income EPS
1,540,000 (880,000) (250,000) 410,000 ( +17.14%) (125,000) 285,000 (96,900) 188,100 $1.881 ( +26.67%)
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