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Leverage nikunj

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Leverage nikunj

  1. 1. Analysis and Impact of Leverage <ul><li>Operating Leverage </li></ul><ul><li>Financial Leverage </li></ul>
  2. 2. What is Leverage?
  3. 3. What is Leverage?
  4. 4. What is Leverage?
  5. 5. 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>
  6. 6. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>
  7. 7. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>EBIT
  8. 8. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT
  9. 9. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS
  10. 10. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
  11. 11. Business Risk <ul><li>The variability or uncertainty of a firm’s operating income (EBIT). </li></ul>FIRM EBIT EPS Stock- holders
  12. 12. 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>
  13. 13. 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>
  14. 15. EBIT Operating Leverage
  15. 16. 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>
  16. 17. 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
  17. 18. 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
  18. 19. Financial Leverage <ul><li>The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock). </li></ul>
  19. 21. EPS Financial Leverage
  20. 22. 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>
  21. 23. Breakeven Analysis Quantity $
  22. 24. Quantity $ Total Revenue
  23. 25. 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>
  24. 26. Quantity $ Total Revenue
  25. 27. Quantity { $ Total Revenue Total Cost FC
  26. 28. Quantity { $ Total Revenue Total Cost FC Q 1 + - } EBIT
  27. 29. Quantity { $ Total Revenue Total Cost FC Break-even point Q 1 + - } EBIT
  28. 30. Operating Leverage <ul><li>What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? </li></ul>
  29. 31. Quantity { $ Total Revenue Total Cost FC Break- even point Q 1 + - } EBIT
  30. 32. Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q 1 + - EBIT
  31. 33. <ul><li>With high operating leverage , an increase in sales produces a relatively larger increase in operating income . </li></ul>
  32. 34. Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q 1 + - EBIT
  33. 35. 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
  34. 36. Breakeven Calculations
  35. 37. Breakeven Calculations <ul><li>Breakeven point (units of output) </li></ul>Q B = F P - V
  36. 38. <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
  37. 39. Breakeven Calculations <ul><li>Breakeven point (sales dollars) </li></ul>S* = F VC S 1 -
  38. 40. <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 -
  39. 41. 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>
  40. 42. 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>
  41. 43. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales
  42. 44. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales =
  43. 45. <ul><li>If we have the data, we can use this formula: </li></ul>Degree of Operating Leverage from Sales Level (S)
  44. 46. <ul><li>If we have the data, we can use this formula: </li></ul>Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT
  45. 47. <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
  46. 48. 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>
  47. 49. 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
  48. 50. 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
  49. 51. 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>
  50. 52. Degree of Financial Leverage DFL = % change in EPS % change in EBIT
  51. 53. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
  52. 54. Degree of Financial Leverage <ul><li>If we have the data, we can use this formula: </li></ul>
  53. 55. Degree of Financial Leverage <ul><li>If we have the data, we can use this formula: </li></ul>DFL = EBIT EBIT - I
  54. 56. 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>
  55. 57. 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
  56. 58. 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
  57. 59. 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>
  58. 60. Degree of Combined Leverage
  59. 61. Degree of Combined Leverage DCL = DOL x DFL
  60. 62. Degree of Combined Leverage DCL = DOL x DFL % change in EPS % change in Sales =
  61. 63. Degree of Combined Leverage DCL = DOL x DFL = % change in EPS % change in Sales change in EPS EPS change in Sales Sales =
  62. 64. Degree of Combined Leverage <ul><li>If we have the data, we can use this formula: </li></ul>
  63. 65. <ul><li>If we have the data, we can use this formula: </li></ul>Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I
  64. 66. 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 =
  65. 67. 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>
  66. 68. 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
  67. 69. 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
  68. 70. An Example: <ul><li>Some Facts </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>
  69. 71. 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>
  70. 72. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
  71. 73. Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT
  72. 74. Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = DOLs = Sales - Variable Costs EBIT
  73. 75. Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000 = 1.714 = DOLs = Sales - Variable Costs EBIT
  74. 76. Levered Company EPS Operating Income Sales
  75. 77. Levered Company EPS Operating Income Sales Operating leverage
  76. 78. Levered Company EPS Operating Income Sales Operating leverage 10%
  77. 79. Levered Company EPS Operating Income Sales Operating leverage 10% 17.14%
  78. 80. Degree of Financial Leverage DFL = EBIT EBIT - I
  79. 81. Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000
  80. 82. Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000 = 1.556
  81. 83. Levered Company EPS Operating Income Sales
  82. 84. Levered Company EPS Operating Income Sales Financial leverage
  83. 85. Levered Company EPS Financial leverage Operating Income Sales 10%
  84. 86. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
  85. 87. Levered Company EPS Financial leverage Operating Income Sales 10% 15.56%
  86. 88. Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I
  87. 89. Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 =
  88. 90. Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000 = 2.667 =
  89. 91. Levered Company EPS Operating Income Sales
  90. 92. Levered Company EPS Operating Income Sales Operating leverage
  91. 93. Levered Company EPS Financial leverage Operating Income Sales Operating leverage
  92. 94. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10%
  93. 95. Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% 26.67%
  94. 96. Levered Company EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage
  95. 97. <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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