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- 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. What is Leverage?
- 3. What is Leverage?
- 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. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>
- 6. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
- 7. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
- 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. 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>
- 11. EBIT Operating Leverage
- 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>
- 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
- 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
- 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>
- 17. EPS Financial Leverage
- 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>
- 19. Breakeven Analysis Quantity $
- 20. Quantity $ Total Revenue
- 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>
- 22. Quantity $ Total Revenue
- 23. Quantity { $ Total Revenue Total Cost FC
- 24. Quantity { $ Total Revenue Total Cost FC Q 1 + - } EBIT
- 25. Quantity { $ Total Revenue Total Cost FC Break-even point Q 1 + - } EBIT
- 26. Operating Leverage <ul><li>What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? </li></ul>
- 27. Quantity { $ Total Revenue Total Cost FC Break- even point Q 1 + - } EBIT
- 28. Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q 1 + - EBIT
- 29. <ul><li>With high operating leverage , an increase in sales produces a relatively larger increase in operating income . </li></ul>
- 30. Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT
- 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
- 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
- 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 -
- 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>
- 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>
- 36. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales =
- 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
- 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
- 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
- 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>
- 41. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
- 42. Degree of Financial Leverage <ul><li>If we have the data, we can use this formula: </li></ul>DFL = EBIT EBIT - I
- 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
- 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
- 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>
- 46. Degree of Combined Leverage DCL = DOL x DFL = % change in EPS % change in Sales change in EPS EPS change in Sales Sales =
- 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 =
- 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>
- 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
- 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
- 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>
- 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>
- 53. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
- 54. Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT
- 55. Levered Company EPS Operating Income Sales
- 56. Levered Company EPS Operating Income Sales Operating leverage
- 57. Levered Company EPS Operating Income Sales Operating leverage 10%
- 58. Levered Company EPS Operating Income Sales Operating leverage 10% 17.14%
- 59. Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000 = 1.556
- 60. Levered Company EPS Operating Income Sales
- 61. Levered Company EPS Operating Income Sales Financial leverage
- 62. Levered Company EPS Financial leverage Operating Income Sales 10%
- 63. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
- 64. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
- 65. Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667 =
- 66. Levered Company EPS Operating Income Sales
- 67. Levered Company EPS Operating Income Sales Operating leverage
- 68. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
- 69. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10%
- 70. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% 26.67%
- 71. Levered Company EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage
- 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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