Leverages

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Leverages

  1. 1. LeveragesPRESENTED BY DHEERAJ
  2. 2. Definition of Leverage1. The use of various financial instruments orborrowed capital, such as margin, to increasethe potential return of an investment.2. The amount of debt used to finance a firmsassets. A firm with significantly more debt thanequity is considered to be highly leveraged.
  3. 3. Classification• There are two types of leverage: – Operating leverage – fixed costs associated with running the firm. – Financial leverage – fixed costs associated with financing the firm.• Degree of leverage – Measure of how much leverage the firm uses.
  4. 4. Operating Leverage• Operating leverage is the ratio of a companys fixed costs to its variable costs.• A firm with relatively high fixed operating costs will experience more variable operating income if sales change.
  5. 5. Effect of operating leverage• More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. $ Rev. $ Rev. TC } Profit TC FC FC QBE Sales QBE Sales
  6. 6. 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.
  7. 7. Degree of Operating Leverage from Sales Level (S)• DOLs = % change in EBIT % change in sales = change in EBIT EBIT change in sales sales
  8. 8. Degree of Operating Leverage from Sales Level (S)DOLs = Sales - Variable Costs EBIT Q(P - V) Q(P - V) - F F = total anticipated fixed costs. P = sales price per unit. V = variable cost per unit.
  9. 9. What does this tell us?• If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- Sales EBIT EPS holders
  10. 10. What does this tell us?• If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- Sales EBIT EPS holders
  11. 11. Financial LeverageThe use of fixed-cost sources of financing(debt, preferred stock) rather than variable-cost sources (common stock).
  12. 12. 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.
  13. 13. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS = change in EBIT EBIT
  14. 14. Degree of Financial Leverage• If we have the data, we can use this formula: DFL = EBIT EBIT - I
  15. 15. 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. Stock- Sales EBIT EPS holders
  16. 16. 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. Stock- Sales EBIT EPS holders
  17. 17. Combined Leverage• 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.
  18. 18. Degree of Combined Leverage DCL = DOL x DFL % change in EPS = % change in Sales change in EPS EPS = change in Sales Sales
  19. 19. 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
  20. 20. What does this tell us?• If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- Sales EBIT EPS holders
  21. 21. What does this tell us?• If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- Sales EBIT EPS holders
  22. 22. Levered CompanySales (100,000 units) 1,400,000Variable Costs 800,000Fixed Costs 250,000Interest paid 125,000Tax rate 34%Common shares outstanding 100,000
  23. 23. Degree of Operating Leverage from Sales Level (S) Sales - Variable Costs DOLs = EBIT 1,400,000 - 800,000 = 350,000 = 1.714
  24. 24. Degree of Financial Leverage DFL = EBIT EBIT - I 350,000 = 225,000 = 1.556
  25. 25. Degree of Combined LeverageDCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 = 225,000 = 2.667

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