Leverage nikunj
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Leverage nikunj

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Leverage nikunj Leverage nikunj Presentation Transcript

  • 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).
    FIRM EBIT
  • Business Risk
    • The variability or uncertainty of a firm’s operating income (EBIT).
    FIRM EBIT EPS
  • Business Risk
    • The variability or uncertainty of a firm’s operating income (EBIT).
    FIRM EBIT EPS Stock- holders
  • Business Risk
    • The variability or uncertainty of a firm’s operating income (EBIT).
    FIRM EBIT EPS Stock- holders
  • 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.
    FIRM EBIT EPS Stock- holders
  • 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 .
    FIRM EBIT EPS Stock- holders
  • 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 $
  • Quantity $ Total Revenue
  • 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).
  • Quantity $ Total Revenue
  • Quantity { $ Total Revenue Total Cost FC
  • Quantity { $ Total Revenue Total Cost FC Q 1 + - } EBIT
  • Quantity { $ Total Revenue Total Cost FC Break-even point Q 1 + - } EBIT
  • Operating Leverage
    • What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?
  • Quantity { $ Total Revenue Total Cost FC Break- even point Q 1 + - } EBIT
  • Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q 1 + - EBIT
    • With high operating leverage , an increase in sales produces a relatively larger increase in operating income .
  • Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT
  • 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
  • Breakeven Calculations
  • Breakeven Calculations
    • Breakeven point (units of output)
    Q B = F P - V
    • Breakeven point (units of output)
    • Q B = breakeven level of Q.
    • F = total anticipated fixed costs.
    • P = sales price per unit.
    • V = variable cost per unit.
    Breakeven Calculations Q B = F P - V
  • Breakeven Calculations
    • Breakeven point (sales dollars)
    S* = F VC S 1 -
    • Breakeven point (sales dollars)
    • S* = breakeven level of sales.
    • F = total anticipated fixed costs.
    • S = total sales.
    • VC = total variable costs.
    Breakeven Calculations S* = F VC S 1 -
  • 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 =
    • 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:
    Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT
    • If we have the data, we can use this formula:
    Degree of Operating Leverage from Sales Level (S) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs 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).
  • 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- holders EBIT EPS Sales
  • 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- holders EBIT EPS Sales
  • 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 DFL = % change in EPS % change in EBIT 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:
    DFL = EBIT 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.
    Stock- holders EBIT EPS Sales
  • 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- holders EBIT EPS Sales
  • 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:
    • If we have the data, we can use this formula:
    Degree of Combined Leverage 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.
    Stock- holders EBIT EPS Sales
  • 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- holders EBIT EPS Sales
  • An Example:
    • Some Facts
    • 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 EPS Financial leverage Operating Income Sales Operating leverage
  • Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT
  • Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = DOLs = Sales - Variable Costs EBIT
  • Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT
  • Levered Company EPS Operating Income Sales
  • Levered Company EPS Operating Income Sales Operating leverage
  • Levered Company EPS Operating Income Sales Operating leverage 10%
  • Levered Company EPS Operating Income Sales Operating leverage 10% 17.14%
  • Degree of Financial Leverage DFL = EBIT EBIT - I
  • Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000
  • Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000 = 1.556
  • Levered Company EPS Operating Income Sales
  • Levered Company EPS Operating Income Sales Financial leverage
  • Levered Company EPS Financial leverage Operating Income Sales 10%
  • Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
  • Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
  • 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 EPS Operating Income Sales
  • Levered Company EPS Operating Income Sales Operating leverage
  • Levered Company EPS Financial leverage Operating Income Sales Operating leverage
  • Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10%
  • Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% 26.67%
  • Levered Company EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage
    • Sales (110,000 units) 1,540,000
    • Variable Costs (880,000)
    • Fixed Costs (250,000)
    • EBIT 410,000 ( +17.14%)
    • Interest (125,000)
    • EBT 285,000
    • Taxes (34%) (96,900)
    • Net Income 188,100
    • EPS $1.881 ( +26.67%)
    Levered Company 10% increase in sales