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# Topic 02

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### Topic 02

1. 1. Topic 02• Operating and Financial Leverage 5-1
2. 2. Chapter Outline• What is leverage?• Break-even analysis• Operating leverage• Financial leverage• Combined leverage• Potential profits or increased risk? 5-2
3. 3. What is Leverage?• Use of special forces and effects to magnify or produce more than the normal results from a given course of action – Can produce beneficial results in favorable conditions – Can produce highly negative results in unfavorable conditions 5-3
4. 4. Leverage in a Business• Determining type of fixed operational costs – Plant and equipment • Eliminates labor in production of inventory – Expensive labor • Lessens opportunity for profit but reduces risk exposure• Determining type of fixed financial costs – Debt financing • Substantial profits but failure to meet contractual obligations can result in bankruptcy – Selling equity • Reduces potential profits but minimize risk exposure 5-4
5. 5. Operating Leverage• Extent to which fixed assets and associated fixed costs are utilized in a business• Operational costs include: – Fixed – Variable – Semivariable 5-5
6. 6. Break-Even Chart: Leveraged Firm 5-6
7. 7. Break-Even Analysis• The break-even point is at 50,000 units, where the total costs and total revenue lines intersect Units = 50,000 .Total Variable Fixed Costs Total Costs Total Revenue Operating IncomeCosts (TVC) (FC) (TC) (TR) (loss)(50,000 X \$0.80) (50,000 X \$2)\$40,000 \$60,000 \$100,000 \$100,000 0 5-7
8. 8. Break-Even Analysis (cont’d)• The break-even point can also be calculated by: Fixed costs = Fixed costs = FC Contribution margin Price – Variable cost per unit P – VC i.e. \$60,000 = \$60,000 = 50,000 units \$2.00 - \$0.80 \$1.20 5-8
9. 9. Volume-Cost-Profit Analysis: Leveraged Firm 5-9
10. 10. A Conservative Approach• Some firms choose not to operate at high degrees of operating leverage – More expensive variable costs may be substituted for automated plant and equipment – This approach may cut into potential profitability of the firm 5-10
11. 11. Break-Even Chart:Conservative Firm 5-11
12. 12. Volume-Cost-Profit Analysis: Conservative Firm 5-12
13. 13. The Risk Factor• Factors influencing decision on maintaining a conservative or leveraged stance include: – Economic condition – Competitive position within industry – Future position – stability versus market leadership – Matching an acceptable return with a desired level of risk 5-13
14. 14. Cash Break-Even Analysis• Helps in analyzing the short-term outlook of a firm• Noncash items are excluded: – Depreciation – Sales (accounts receivable rather than cash) – Purchase of materials – Accounts payable 5-14
15. 15. Degree of Operating Leverage (DOL)• Percentage change in operating income – Occurs as a result of a percentage change in units sold – Computed only over a profitable range of operations – Directly proportional to the firm’s break-even point DOL = Percent change in operating income Percent change in unit volume 5-15
16. 16. Operating Income or Loss 5-16
17. 17. Computation of DOL• Leveraged firm:DOL = Percent change in operating income = \$24,000 X 100 Percent change in unit volume \$36,000 20,000 X 100 80,000 = 67% = 2.7 25%• Conservative firm:DOL = Percent change in operating income = \$8,000 X 100 Percent change in unit volume \$20,000 20,000 X 100 80,000 = 40% = 1.6 25% 5-17
18. 18. Algebraic Formula for DOL DOL = Q (P – VC) Q (P – VC) – FCWhere,• Q = Quantity at which DOL is computed• P = Price per unit• VC = Variable costs per unit• FC = Fixed costs• For the leveraged firm, assume Q = 80,000, with P = \$2, VC = \$0.80, and FC = \$60,000:DOL = 80,000 (\$2.00 - \$0.80) ; 80,000 (\$2.00 - \$0.80) - \$60,000 = 80,000 (\$1.20) = \$96,000 ; 80,000 (\$1.20) - \$60,000 \$96,000 - \$60,000i.e. DOL = 2.7 5-18
19. 19. Limitations of Analysis• Weakening of price in an attempt to capture an increasing market• Cost overruns when moving beyond an optimum-size operation• Relationships are not fixed 5-19
20. 20. Nonlinear Break-Even Analysis 5-20
21. 21. Financial Leverage• Reflects the amount of debt used in the capital structure of the firm – Determines how the operation is to be financed – Determines the performance between two firms having equal operating capabilities BALANCE SHEET Assets Liabilities and Net Worth Operating leverage Financial leverage 5-21
22. 22. Impact on Earnings• Examine two financial plans for a firm, where \$200,000 is required to carry the assets Total Assets = \$200,000 Plan A (leveraged) Plan B (conservative)Debt (8% interest) \$150,000 (\$12,000 interest) \$50,000 (\$4,000 interest)Common stock 50,000 (8000 shares at \$6.25) 150,000 (24,000 shares at \$6.25)Total financing \$200,000 \$200,000 5-22
23. 23. Impact of Financing Plan on Earnings per Share 5-23
24. 24. Financing Plans and Earnings per Share 5-24
25. 25. Degree of Financial Leverage DFL = Percent change in EPS Percent change in EBIT• For the purpose of computation, it can be restated as: DFL = EBIT . EBIT – I• Plan A (Leveraged):DFL = EBIT = \$36,000 = \$36,000 = 1.5 EBIT – I \$36,000 - \$12,000 \$24,000• Plan B (Conservative):DFL = EBIT = \$36,000 = \$36,000 = 1.1 EBIT – I \$36,000 - \$4,000 \$32,000 5-25
26. 26. Limitations to Use of Financial Leverage• Beyond a point, debt financing is detrimental to the firm – Lenders will perceive a greater financial risk – Common stockholders may drive down the price• Recommended for firms that are: – In an industry that is generally stable – In a positive stage of growth – Operating in favorable economic conditions 5-26
27. 27. Combining Operating and Financial Leverage• Combined leverage: when both leverages allow a firm to maximize returns – Operating leverage: • Affects the asset structure of the firm • Determines the return from operations – Financial leverage: • Affects the debt-equity mix • Determines how the benefits received will be allocated 5-27
28. 28. Combined Leverage Influence on the Income Statement 5-28
29. 29. Combining Operatingand Financial Leverage 5-29
30. 30. Operating and Financial Leverage 5-30
31. 31. Degree of Combined Leverage• Uses the entire income statement• Shows the impact of a change in sales or volume on bottom-line earnings per share DCL = Percentage change in EPS ; Percentage change in sales (or volume)• Using data from Table 5-7:Percent change in EPS = \$1.50 X 100 \$1.50 = 100% = 4Percent change in sales \$40,000 X 100 25% \$160,000 5-31
32. 32. Degree of Combined Leverage (cont’d) DCL = Q (P – VC) , Q (P – VC) – FC – IFrom Table 5-7,• Q (Quantity) = 80,000; P (Price per unit) = \$2.00; VC (Variable costs per unit) = \$0.80; FC (Fixed costs) = \$60,000; and I (Interest) = \$12,000.DCL = 80,000 (\$2.00 - \$0.80) = 80,000 (\$2.00 - \$0.80) - \$60,000 - \$12,000 = 80,000 (\$1.20) = 80,000 (\$1.20) - \$72,000DCL = \$96,000 = \$96,000 = 4 \$96,000 - \$72,000 \$24,000 5-32
33. 33. END 5-33
34. 34. Q&A 5-34
35. 35. Thank You. 5-35

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