Chapter15v5.ppt

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Analysis and Impact of Leverage

Chapter 15

Goal of a firm

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Managers' objective is to maximize stockholders' wealth--maximize the price of the firm's stock. We noted in an earlier chapter that the capital structure that produces the lowest WACC (risk) is also the one that maximizes share price.

Risk Variability of the expected net income (EPS)

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Risk Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk

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Risk Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Revenue -Variable Cost Contribution margin -Fixed cost =EBIT/operating profits -Interest =NI

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Risk Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Business Risk Risk Due to Operations

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Risk Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Business Risk Risk Due to Operations Measured by variability of EBIT (earnings before interest and taxes)

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Risk Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Business Risk Risk Due to Operations Measured by variability of EBIT (earnings before interest and taxes) Coefficient of Variation of EBIT

=

Standard Deviation of EBIT Expected EBIT

Risk

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Variability of revenues from expected Two types of Risk: Business Risk & Financial Risk Financial Risk Risk due to raising money with fixed income securities

Business Risk Major determinants of business risk 1. Demand Variability 2. Sales Price Variability 3. Input Price variability. 4. Inability to adjust output prices for a change in input prices-a utility can transfer costs more easily 5. Operating Leverage--the extent to which costs are 'fixed' (the ratio of fixed cost to total cost).

Business risk not only varies from industry to industry, it varies among firms in a given industry. Business risk of a firm can change over time.

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Risk

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Financial Risk Risk due to raising money with fixed income securities Financial risk is high with high levels of debt financing

Risk

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Financial Risk Risk due to raising money with fixed income securities Financial risk is high with high levels of debt financing Financial leverage - the use of fixed income securities to finance a portion of assets

Risk

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Financial Risk Risk due to raising money with fixed income securities Financial risk is high with high levels of debt financing Financial leverage - the use of fixed income securities to finance a portion of assets Example Firm A is an all equity firm -- it has no financial leverage

Risk

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Financial Risk Risk due to raising money with fixed income securities Financial risk is high with high levels of debt financing Financial leverage - the use of fixed income securities to finance a portion of assets Example Firm A is an all equity firm -- it has no financial leverage Firm B is financed by 50% debt and 50% equity -- it uses financial leverage

Risk

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Notes: 1. Business risk is largely determined by technology and by industry/market conditions, although management decisions, to some extent, do matter. 2. Financial risk is largely management determined. 3. If business risk is high, financial risk (leverage) should be restrained.

Break-even Analysis The point of sales where operating profits are zero. The point where revenues barely cover all costs. Steps to Solution Determine the quantity of output which results in an EBIT = $0

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Break-even Analysis Steps to Solution Determine the quantity of output which results in an EBIT = $0 Shows output necessary to cover operating (not financial) costs

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Break-even Analysis Steps to Solution Determine the quantity of output which results in an EBIT = $0 Shows output necessary to cover operating (not financial) costs Calculate EBIT at various output levels

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Break-even Analysis Steps to Solution Determine the quantity of output which results in an EBIT = $0 Shows output necessary to cover operating (not financial) costs Calculate EBIT at various output levels Applications Capital Expenditure Analysis

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Break-even Analysis Steps to Solution Determine the quantity of output which results in an EBIT = $0 Shows output necessary to cover operating (not financial) costs Calculate EBIT at various output levels Applications Capital Expenditure Analysis Determining Prices Evaluating Fixed vs. Variable Costs

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Break-even Analysis Assumptions Fixed costs remain constant as quantity changes Fixed Costs Includes: Salaries, Depreciation, Rent

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Break-even Analysis Assumptions Fixed costs remain constant as quantity changes Fixed Costs Includes: Salaries, Depreciation, Rent

 Variable costs vary as quantity of output changes: they are constant per unit of output Variable Costs Includes: Materials, Labor, Commissions

Drop Semivariable costs

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Break-even Analysis Assumptions Fixed costs remain constant as quantity changes

 Variable costs vary as quantity of output changes: they are constant per unit of output Costs $ Variable Costs

Fixed Costs Quantity Sold

Break-even Analysis Assumptions Fixed costs remain constant as quantity changes Fixed Costs Includes: Salaries, Depreciation, Rent

 Variable costs vary as quantity of output changes: they are constant per unit of output Variable Costs Includes: Materials, Labor, Commissions

 Revenues are quantity sold times price per unit

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Break-even Analysis Calculation of Break-even Quantity

EBIT = Sales – Variable Costs - Fixed Costs

Find Quantity which results in EBIT = $0

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Break-even Analysis

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Calculation of Break-even Quantity Trial and Error Method Choose arbitrary output level Calculate EBIT If EBIT < 0, choose a larger output level If EBIT > 0, choose a lower output level Continue until find a level of output which results in EBIT = $0

Break-even Analysis Calculation of Break-even Quantity Algebraic Analysis

F QB = P–V Where: QB P F V

= = = =

Break-even Quantity Price per Unit Total Fixed Costs Variable Costs per Unit

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Break-even Analysis Calculation of Break-even Quantity Example:

F QB = P–V Fixed Costs = $1,000,000 per year Price = $800/unit Variable Costs = $400/unit

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Break-even Analysis Calculation of Break-even Quantity Example:

F QB = P–V Fixed Costs = $1,000,000 per year Price = $800/unit Variable Costs = $400/unit

QB =

$1,000,000 $800 – $400

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Break-even Analysis Calculation of Break-even Quantity Example:

F QB = P–V Fixed Costs = $1,000,000 per year Price = $800/unit Variable Costs = $400/unit

QB =

$1,000,000 $800 – $400

= 2,500 Units

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Break-even Analysis Calculation of Break-even Sales Level (S*) To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P

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Break-even Analysis Calculation of Break-even Sales Level (S*) To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P S* = 2,500 units x $800

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Break-even Analysis Calculation of Break-even Sales Level (S*) To Find S* for a single product use Break-even Quantity (QB):

S* = QB x P S* = 2,500 units x $800 = $2,000,000

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Break-even Analysis

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Calculation of Break-even Sales Level (S*) May want to Calculate the Break-even Sales Level (S*) for the entire firm with many products

Break-even Analysis

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Calculation of Break-even Sales Level (S*) May want to Calculate the Break-even Sales Level (S*) for the entire firm with many products Calculate from Income Statement data at a particular Sales Level

Break-even Analysis

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Calculation of Break-even Sales Level (S*) May want to Calculate the Break-even Sales Level (S*) for the entire firm with many products Calculate for Income Statement at one Sales Level

F S* = 1 - VC S S = Dollar Level of Sales VC = Total Dollar Variable Costs

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Break-even Analysis Calculation of Break-even Sales Level (S*)

May want to Calculate the Break-even Sales Level (S*) for the entire firm with many products Calculate for Income Statement at one Sales Level

F S* = 1 - VC S

Example: S = Dollar Level of Sales VC = Total Dollar Variable Costs $1,000,000 S* = 1 – $1,500,000 $3,000,000

= $3,000,000 = $1,500,000

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Break-even Analysis Calculation of Break-even Sales Level (S*)

May want to Calculate the Break-even Sales Level (S*) for the entire firm with many products Calculate for Income Statement at one Sales Level

F S* = 1 - VC S

Example: S = Dollar Level of Sales VC = Total Dollar Variable Costs

= $3,000,000 = $1,500,000

$1,000,000 S* = 1 – $1,500,000 = $2,000,000 $3,000,000

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Break-even Analysis Graphical Analysis of Break-even Point Sales & Costs $

$1,000,000

Fixed Costs

Quantity of Units

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Break-even Analysis Graphical Analysis of Break-even Point Sales & Costs $ Variable Costs

$1,000,000

Fixed Costs

Quantity of Units

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Break-even Analysis Graphical Analysis of Break-even Point Sales & Costs $

Total Costs

Variable Costs

$1,000,000

Fixed Costs

Quantity of Units

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Break-even Analysis Graphical Analysis of Break-even Point Sales & Costs $

Sales Total Costs

Variable Costs

$1,000,000

Fixed Costs

Quantity of Units

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Break-even Analysis Graphical Analysis of Break-even Point Sales & Costs $

Sales Total Costs

$2,000,000

Variable Costs

$1,000,000

Fixed Costs

QB = 2,500 Quantity of Units

Break-even Analysis

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Limitations: 1. The sales-volume-cost-profit relationship is assumed to be linear—it may not be. In the real world It is not, except for a small range of sales. 2. Cost-price structure of the firm is assumed to remains constant. It generally does not. 3. Sales price per unit is assumed to be constant regardless of the output. This is not the case in the real world—you have to ? Price if you want to sell more.

Operating Leverage

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Degree of Operating Leverage • With FIXED operating costs, there will be operating leverage • DOL measures the sensitivity of EBIT to changes in sales. DOL of a company is different at different levels of sales.

• High DOL implies that a relatively small change in sales will result in large change in the operating income (EBIT)

Operating Leverage

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Degree of Operating Leverage Operating Leverage is responsiveness of a firm’s EBIT to fluctuations in Sales

Operating Leverage

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Degree of Operating Leverage Operating Leverage is responsiveness of a firm’s EBIT to fluctuations in Sales Degree of Operating Leverage (DOL) Measurement of Operating Leverage For a unique level of sales, DOL changes as sales change.

Operating Leverage

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Degree of Operating Leverage Operating Leverage is responsiveness of a firm’s EBIT to fluctuations in Sales Degree of Operating Leverage (DOL) Measurement of Operating Leverage For a unique level of sales, DOL changes as sales change.

% Change in EBIT DOLS = % Change in Sales

Unique Level of Sales

Operating Leverage Measurement of DOL Calculation using per unit information:

Q(P – V) DOLS = Q(P – V) – F

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Operating Leverage Measurement of DOL Calculation using per unit information:

Q(P – V) DOLS = Q(P – V) – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

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Operating Leverage Measurement of DOL Calculation using per unit information:

Q(P – V) DOLS = Q(P – V) – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,750(800 – 400) DOL3,750 units = 3,750(800 – 400) – 1,000,000

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Operating Leverage Measurement of DOL Calculation using per unit information:

Q(P – V) DOLS = Q(P – V) – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,750(800 – 400) DOL3,750 units = 3,750(800 – 400) – 1,000,000 = 3 times

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Operating Leverage Measurement of DOL Calculation using per unit information:

Q(P – V) DOLS = Q(P – V) – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,750(800 – 400) DOL3,750 units = 3,750(800 – 400) – 1,000,000 Interpretation: If sales change 1%, then

= 3 times EBIT will change 3% in the same direction.

Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

Sales 3,750 units x $3,000,000 $800 per unit $400 per unit $1,000,000 per year.

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units Variable Costs $800 per unit x $1,500,000 $400 per unit $1,000,000 per year.

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,000,000 – 1,500,00 DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,000,000 – 1,500,00 DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000 = 3 times

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Operating Leverage Measurement of DOL Calculation using Income Statement Information

S – VC DOLS = S – VC – F Example:

Q = Price = Variable costs = Fixed Costs =

3,750 units $800 per unit $400 per unit $1,000,000 per year.

3,000,000 – 1,500,00 DOL3,750 units = 3,000,000 – 1,500,000 – 1,000,000 = 3 times Same Answer as before

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Operating Leverage Degree of Operating Leverage

Degree of Operating Leverage is highest when the firm is closest to break-even point--DOL falls as sales rise

Quantity 2,500 (QB) 3,250 3,750 5,000

DOL Undefined 4.33 3 2

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Operating Leverage Degree of Operating Leverage

Degree of Operating Leverage is highest when the firm is closest to break-even point--DOL falls as sales rise Quantity 2,500 (QB) 3,250 3,750 5,000

DOL Undefined 4.33 3 2

The higher the sales level above break-even, the less EBIT (in %) changes as sales change

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Operating Leverage Degree of Operating Leverage

Degree of Operating Leverage is highest when the firm is closest to break-even point--DOL falls as sales rise Quantity 2,500 (QB) 3,250 3,750 5,000

DOL Undefined 4.33 3 2

The higher the sales level above break-even, the less EBIT(in %) changes as sales change If Fixed Costs = $0, Degree of Operating Leverage = 1

Financial Leverage Degree of Financial Leverage Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock

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Financial Leverage

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Degree of Financial Leverage Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock

Financial Leverage measures changes in earnings per share (NI) as EBIT changes.

Financial Leverage

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Degree of Financial Leverage Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock

Financial Leverage measures changes in earnings per share as EBIT changes. Degree of Financial Leverage (DFL) at one level of EBIT:

% Change in EPS DFLEBIT = % Change in EBIT Unique Level of EBIT

Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I

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Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I

Total Fixed Financing Costs

Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I Example:

EBIT = $500,000 Interest Charges = $200,000

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Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I Example:

EBIT = $500,000 Interest Charges = $200,000 500,000 DFLEBIT=500,000 = 500,000 – 200,000

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Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I Example:

EBIT = $500,000 Interest Charges = $200,000 500,000 DFLEBIT=500,000 = 500,000 – 200,000 = 1.67 times

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Financial Leverage Measurement of DFL EBIT DFLEBIT = EBIT – I Example:

EBIT = $500,000 Interest Charges = $200,000 500,000 DFLEBIT=500,000 = 500,000 – 200,000 = 1.67 times

Interpretation: For 1% change in EBIT (from an existing level of $500,000) Earnings Per Share will change 1.67%

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DFL S - VC - F DFL = --------------------S - VC - F - I

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Combined Leverage Degree of Combined Leverage Measures changes in Earnings Per Share given changes in Sales

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Combined Leverage Degree of Combined Leverage Measures changes in Earnings Per Share given changes in Sales Combines both Operating and Financial Leverage

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Combined Leverage Degree of Combined Leverage Measures changes in Earnings Per Share given changes in Sales Combines both Operating and Financial Leverage Computed for a specific level of sales

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Combined Leverage Degree of Combined Leverage Measures changes in Earnings Per Share given changes in Sales Combines both Operating and Financial Leverage Computed for a specific level of sales

% Change in EPS DCLS = % Change in Sales Unique Level of Sales

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Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT

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Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0

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Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0 x 1.67

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Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0 x 1.67

= 5.0 times

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Combined Leverage Measurement of DCL DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0 x 1.67

= 5.0 times Interpretation: When sales change 1%, Earnings Per Share (NI) will change 5.0%

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Combined Leverage Measurement of DCL--Alternative Computation DCLS =

Q(P – V) Q(P – V) – F – I

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Combined Leverage Measurement of DCL--Alternative Computation DCLS = Q = Price = Variable costs = Fixed Costs = Interest =

Example:

Q(P – V) Q(P – V) – F – I 3,750 units $800 per unit $400 per unit $1,000,000 per year $200,000 per year

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Combined Leverage Measurement of DCL--Alternative Computation DCLS = Q = Price = Variable costs = Fixed Costs = Interest =

Example:

Q(P – V) Q(P – V) – F – I 3,750 units $800 per unit $400 per unit $1,000,000 per year $200,000 per year

3,750(800 – 400) DCLS = 3,750(800 – 400) – 1,000,000 – 200,000

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Combined Leverage Measurement of DCL--Alternative Computation DCLS = Q = Price = Variable costs = Fixed Costs = Interest =

Example:

Q(P – V) Q(P – V) – F – I 3,750 units $800 per unit $400 per unit $1,000,000 per year $200,000 per year

3,750(800 – 400) DCLS = 3,750(800 – 400) – 1,000,000 – 200,000 = 5 times

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Combined Leverage Measurement of DCL--Alternative Computation DCLS = Q = Price = Variable costs = Fixed Costs = Interest =

Example:

Q(P – V) Q(P – V) – F – I 3,750 units $800 per unit $400 per unit $1,000,000 per year $200,000 per year

3,750(800 – 400) DCLS = 3,750(800 – 400) – 1,000,000 – 200,000 = 5 times Interpretation: When sales change 1%, Earnings Per Share will change 5.0%

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Measurement of DCL--Alternative ComputationUsing income statement. S - VC - F DCLS = --------------------S - VC - F - I