Fm10e ch15

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  • 12
  • Fm10e ch15

    1. 1. <ul><li>Operating Leverage </li></ul><ul><li>Financial Leverage </li></ul> 2005, Pearson Prentice Hall Chapter 15 – Analysis and Impact of Leverage
    2. 2. What is Leverage?
    3. 3. What is Leverage?
    4. 4. Two concepts that enhance our understanding of risk... <ul><li>1) Operating Leverage - affects a firm’s business risk . </li></ul><ul><li>2) Financial Leverage - affects a firm’s financial risk . </li></ul>
    5. 5. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>
    6. 6. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
    7. 7. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
    8. 8. Business Risk <ul><li>Affected by: </li></ul><ul><li>Sales volume variability </li></ul><ul><li>Competition </li></ul><ul><li>Product diversification </li></ul><ul><li>Operating leverage </li></ul><ul><li>Growth prospects </li></ul><ul><li>Size </li></ul>
    9. 9. Operating Leverage <ul><li>The use of fixed operating costs as opposed to variable operating costs . </li></ul><ul><li>A firm with relatively high fixed operating costs will experience more variable operating income if sales change. </li></ul>
    10. 11. EBIT Operating Leverage
    11. 12. Financial Risk <ul><li>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 . </li></ul>
    12. 13. Financial Risk <ul><li>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. </li></ul>FIRM EBIT EPS Stock- holders
    13. 14. Financial Risk <ul><li>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 . </li></ul>FIRM EBIT EPS Stock- holders
    14. 15. Financial Leverage <ul><li>The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock). </li></ul>
    15. 17. EPS Financial Leverage
    16. 18. Breakeven Analysis <ul><li>Illustrates the effects of operating leverage. </li></ul><ul><li>Useful for forecasting the profitability of a firm, division, or product line. </li></ul><ul><li>Useful for analyzing the impact of changes in fixed costs, variable costs, and sales price. </li></ul>
    17. 19. Breakeven Analysis Quantity $
    18. 20. Quantity $ Total Revenue
    19. 21. Costs <ul><li>Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions). </li></ul>
    20. 22. Quantity $ Total Revenue
    21. 23. Quantity { $ Total Revenue Total Cost FC
    22. 24. Quantity { $ Total Revenue Total Cost FC Q 1 + - } EBIT
    23. 25. Quantity { $ Total Revenue Total Cost FC Break-even point Q 1 + - } EBIT
    24. 26. Operating Leverage <ul><li>What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? </li></ul>
    25. 27. Quantity { $ Total Revenue Total Cost FC Break- even point Q 1 + - } EBIT
    26. 28. Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q 1 + - EBIT
    27. 29. <ul><li>With high operating leverage , an increase in sales produces a relatively larger increase in operating income . </li></ul>
    28. 30. Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT
    29. 31. Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses! Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT
    30. 32. <ul><li>Breakeven point (units of output) </li></ul><ul><li>Q B = breakeven level of Q. </li></ul><ul><li>F = total anticipated fixed costs. </li></ul><ul><li>P = sales price per unit. </li></ul><ul><li>V = variable cost per unit. </li></ul>Breakeven Calculations Q B = F P - V
    31. 33. <ul><li>Breakeven point (sales dollars) </li></ul><ul><li>S* = breakeven level of sales. </li></ul><ul><li>F = total anticipated fixed costs. </li></ul><ul><li>S = total sales. </li></ul><ul><li>VC = total variable costs. </li></ul>Breakeven Calculations S* = F VC S 1 -
    32. 34. Analytical Income Statement <ul><li>sales </li></ul><ul><li>- variable costs </li></ul><ul><li>- fixed costs </li></ul><ul><li>operating income </li></ul><ul><li>- interest </li></ul><ul><li>EBT </li></ul><ul><li>- taxes </li></ul><ul><li>net income </li></ul>
    33. 35. Degree of Operating Leverage (DOL) <ul><li>Operating leverage : by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income . </li></ul><ul><li>This “multiplier effect” is called the degree of operating leverage . </li></ul>
    34. 36. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales =
    35. 37. <ul><li>If we have the data, we can use this formula: </li></ul>Degree of Operating Leverage from Sales Level (S) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs EBIT
    36. 38. What does this tell us? <ul><li>If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). </li></ul>Stock- holders EBIT EPS Sales
    37. 39. What does this tell us? <ul><li>If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). </li></ul>Stock- holders EBIT EPS Sales
    38. 40. Degree of Financial Leverage (DFL) <ul><li>Financial leverage : by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share . </li></ul><ul><li>This “multiplier effect” is called the degree of financial leverage . </li></ul>
    39. 41. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
    40. 42. Degree of Financial Leverage <ul><li>If we have the data, we can use this formula: </li></ul>DFL = EBIT EBIT - I
    41. 43. What does this tell us? <ul><li>If DFL = 3 , then a 1% increase in operating income will result in a 3% increase in earnings per share. </li></ul>Stock- holders EBIT EPS Sales
    42. 44. What does this tell us? <ul><li>If DFL = 3 , then a 1% increase in operating income will result in a 3% increase in earnings per share. </li></ul>Stock- holders EBIT EPS Sales
    43. 45. Degree of Combined Leverage (DCL) <ul><li>Combined leverage : by using operating leverage and financial leverage , a small change in sales is magnified into a larger change in earnings per share . </li></ul><ul><li>This “multiplier effect” is called the degree of combined leverage . </li></ul>
    44. 46. Degree of Combined Leverage DCL = DOL x DFL = % change in EPS % change in Sales change in EPS EPS change in Sales Sales =
    45. 47. Degree of Combined Leverage <ul><li>If we have the data, we can use this formula: </li></ul>DCL = Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I =
    46. 48. What does this tell us? <ul><li>If DCL = 4 , then a 1% increase in sales will result in a 4% increase in earnings per share. </li></ul>
    47. 49. What does this tell us? <ul><li>If DCL = 4 , then a 1% increase in sales will result in a 4% increase in earnings per share. </li></ul>Stock- holders EBIT EPS Sales
    48. 50. What does this tell us? <ul><li>If DCL = 4 , then a 1% increase in sales will result in a 4% increase in earnings per share. </li></ul>Stock- holders EBIT EPS Sales
    49. 51. In-class Project: <ul><li>Based on the following information on Levered Company, answer these questions: </li></ul><ul><li>1) If sales increase by 10%, what should happen to operating income ? </li></ul><ul><li>2) If operating income increases by 10%, what should happen to EPS ? </li></ul><ul><li>3) If sales increase by 10%, what should be the effect on EPS ? </li></ul>
    50. 52. Levered Company <ul><li>Sales (100,000 units) $1,400,000 </li></ul><ul><li>Variable Costs $800,000 </li></ul><ul><li>Fixed Costs $250,000 </li></ul><ul><li>Interest paid $125,000 </li></ul><ul><li>Tax rate 34% </li></ul><ul><li>Common shares outstanding 100,000 </li></ul>
    51. 53. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
    52. 54. Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT
    53. 55. Levered Company EPS Operating Income Sales
    54. 56. Levered Company EPS Operating Income Sales Operating leverage
    55. 57. Levered Company EPS Operating Income Sales Operating leverage 10%
    56. 58. Levered Company EPS Operating Income Sales Operating leverage 10% 17.14%
    57. 59. Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000 = 1.556
    58. 60. Levered Company EPS Operating Income Sales
    59. 61. Levered Company EPS Operating Income Sales Financial leverage
    60. 62. Levered Company EPS Financial leverage Operating Income Sales 10%
    61. 63. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
    62. 64. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
    63. 65. Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667 =
    64. 66. Levered Company EPS Operating Income Sales
    65. 67. Levered Company EPS Operating Income Sales Operating leverage
    66. 68. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
    67. 69. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10%
    68. 70. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% 26.67%
    69. 71. Levered Company EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage
    70. 72. <ul><li>Sales (110,000 units) 1,540,000 </li></ul><ul><li>Variable Costs (880,000) </li></ul><ul><li>Fixed Costs (250,000) </li></ul><ul><li>EBIT 410,000 ( +17.14%) </li></ul><ul><li>Interest (125,000) </li></ul><ul><li>EBT 285,000 </li></ul><ul><li>Taxes (34%) (96,900) </li></ul><ul><li>Net Income 188,100 </li></ul><ul><li>EPS $1.881 ( +26.67%) </li></ul>Levered Company 10% increase in sales

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