The document discusses the concepts of operating leverage and financial leverage, highlighting their impact on a firm's business risk and financial risk respectively. Operating leverage relates to the use of fixed operating costs, which can amplify changes in operating income with sales volume fluctuations, while financial leverage pertains to fixed-cost financing that influences a firm's earnings per share and insolvency risk. Additionally, the document covers breakeven analysis, degree of operating leverage, degree of financial leverage, and the importance of analyzing future cash flows for determining appropriate financial leverage.

1. Dr. S. Ghose

2. 1) Operating Leverage -
affects a firm’s business risk.
2) Financial Leverage - affects
a firm’s financial risk.

3. Business Risk
The variability or uncertainty of a
firm’s operating income (EBIT).
FIRMEBIT EPS
Stock-
holders

4. Business Risk
Affected by:
Sales volume variability
Competition
Cost variability
Product diversification
Product demand
Operating Leverage

5. Operating Leverage
 One potential “effect” caused by the
presence of operating leverage is that a
change in the volume of sales results in a
“more than proportional” change in
operating profit (or loss).
Operating Leverage -- The use of fixed
operating costs by the firm.

6. 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.

7. 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.
FIRMEBIT EPS
Stock-
holders

8. Financial Leverage
The use of fixed-cost sources of
financing (debt, preferred
stock) rather than variable-
cost sources (common stock).

9. 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.

10. 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).

11. Quantity
{
Rs.
Total Revenue
Total Cost
FC
Break-
even
point
Q1
+
-
} EBIT

12. Operating Leverage
What happens if the firm
increases its fixed operating costs
and reduces (or eliminates) its
variable costs?

13. Quantity
{
Rs.
Total Revenue
Total Cost
FC
Break-
even
point
Q1
+
-
} EBIT

14. With high operating leverage, an
increase in sales produces a
relatively larger increase in
operating income.

15. Quantity
{
Rs.
Total Revenue
Total Cost
= FixedFC
Break-
even
point
}
Q1
+
-
EBIT

16. Trade-off:
If the firm has
a higher breakeven
Point and if sales are not
high enough, the firm
will not meet its fixed
expenses

17. Breakeven Calculations
Breakeven point (units of output)
QB = breakeven level of Q.
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.
QB =
F
P - V

18. Breakeven Calculations
Breakeven point (sales in Rs.)
S* = breakeven level of sales.
F = total anticipated fixed costs.
S = total sales.
VC = total variable costs.
S* =
F
VC
S
1 -

19. Analytical Income Statement
sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
net income
}contribution margin
EBT (1 - t) = Net Income,
so,
Net Income / (1 - t) = EBT

20. 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.

21. DOLs = % change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales
=
Degree of Operating Leverage
from Sales Level (S)

22. Degree of Operating Leverage
from Sales Level (S)
 If we have the data, we can use this
formula:
Q(P - V)
Q(P - V) - F
=
DOLs =
Sales - Variable Costs
EBIT

23. Interpretation
If DOL = 2, then a 1% increase in
sales will result in a 2% increase
in operating income (EBIT).
Stock-
holdersEBIT EPSSales

24. Impact of Operating Leverage on Profits
Firm F Firm V Firm 2F
Sales Rs.10 Rs.11 Rs.19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit Rs. 1 Rs. 2 Rs. 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
(in thousands)

25. Firm F Firm V Firm 2F
Sales Rs.15 Rs.16.5 Rs.29.25
Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
Operating Profit Rs. 5 Rs. 4 Rs.10.75
Percentage
Change in EBIT* 400% 100% 330%
(in thousands)
* (EBITt - EBIT t-1) / EBIT t-1
If there is 50% increase in sales for next year.

26.  Firm F is the most “sensitive” firm -- for it, a 50%
increase in sales leads to a 400% increase in EBIT.
 It is a mistake to assume that the firm with the largest
absolute or relative amount of fixed costs automatically
shows the most dramatic effects of operating leverage.

27. Break-Even Analysis
 Profits refers to operating profits before taxes
(i.e., EBIT) and excludes debt interest and
dividend payments.
Break-Even Analysis -- A technique for
studying the relationship among fixed costs,
variable costs, sales volume, and profits. Also
called cost/volume/profit (C/V/P) analysis.

28. Break-Even Chart
QUANTITY PRODUCED AND SOLD
0 1,000 2,000 3,000 4,000 5,000 6,000 7,000
Total Revenues
Profits
Fixed Costs
Variable Costs
Losses
REVENUESANDCOSTS
(Rs.thousands)
175
250
100
50
Total Costs

29. Interpretation of the DOL
 DOL is a quantitative measure of the “sensitivity” of a
firm’s operating profit to a change in the firm’s sales.
 The closer that a firm operates to its break-even point,
the higher is the absolute value of its DOL.
 When comparing firms, the firm with the highest DOL
is the firm that will be most “sensitive” to a change in
sales.
 DOL is only one component of business risk and
becomes “active” only in the presence of sales and
production cost variability.
 DOL magnifies the variability of operating profits
and, hence, business risk.

30. 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.

31. DFL = % change in EPS
% change in EBIT
change in EPS
EPS
change in EBIT
EBIT
Degree of Financial Leverage
=

32. Degree of Financial Leverage
 If we have the data, we can use this formula:
DFL = EBIT
EBIT - I

33. If DFL = 3, then a 1% increase in
operating income will result in a 3%
increase in earnings per share.
Stock-
holdersEBIT EPSSales

34. 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.

35. DCL = DOL x DFL
Degree of Combined Leverage
=
% change in EPS
% change in Sales
change in EPS
EPS
change in Sales
Sales
=

36. 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
=

37. If DCL = 4, then a 1% increase in
sales will result in a 4% increase in
earnings per share.
Stock-
holdersEBIT EPSSales

38. EBIT-EPS Break-Even, or Indifference, Analysis
Calculate EPS for a given level of EBIT at a given
financing structure.
EBIT-EPS Break-Even Analysis -- Analysis of the
effect of financing alternatives on earnings per
share. The break-even point is the EBIT level
where EPS is the same for two (or more)
alternatives.
(EBIT - I) (1 - t) - Pref. Div.
# of Common Shares
EPS =

39. EBIT-EPS Chart
 Current common equity shares = 50,000
 Rs.1 million in new financing of either:
 All C.S. sold at Rs.20/share (50,000 shares)
 All debt with a coupon rate of 10%
 All P.S. with a dividend rate of 9%
 Expected EBIT = Rs.500,000
 Income tax rate is 30%
ABC Ltd has Rs.2 million in LT financing (100%
common stock equity).

40. EBIT-EPS Calculation with New Equity Financing
EBIT Rs.500,000 Rs.150,000*
Interest 0 0
EBT Rs.500,000 Rs.150,000
Taxes (30% x EBT) 150,000 45,000
EAT Rs.350,000 Rs.105,000
Preferred Dividends 0 0
EACS Rs.350,000 Rs.105,000
# of Shares 100,000 100,000
EPS Rs.3.50 Rs.1.05
Common Stock Equity Alternative
* A second analysis using Rs.150,000 EBIT rather than the expected EBIT

41. EBIT-EPS Chart
0 100 200 300 400 500 600 70
EBIT (Rs. thousands)
EarningsperShare(Rs.)
0
1
2
3
4
5
6
Common

42. EBIT-EPS Calculation with New Debt Financing
EBIT Rs.500,000 Rs.150,000*
Interest 100,000 100,000
EBT Rs.400,000 Rs. 50,000
Taxes (30% x EBT) 120,000 15,000
EAT Rs.280,000 Rs. 35,000
Preferred Dividends 0 0
EACS Rs.280,000 Rs. 35,000
# of Shares 50,000 50,000
EPS Rs.5.60 Rs.0.70
Long-term Debt Alternative

43. EBIT-EPS Chart
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
EarningsperShare(Rs.)
0
1
2
3
4
5
6
Common
Debt
Indifference point
between debt and
common stock
financing

44. EBIT-EPS Calculation with New Preferred Financing
EBIT Rs.500,000 Rs.150,000*
Interest 0 0
EBT Rs.500,000 Rs.150,000
Taxes (30% x EBT) 150,000 45,000
EAT Rs.350,000 Rs.105,000
Preferred Dividends 90,000 90,000
EACS Rs.260,000 Rs. 15,000
# of Shares 50,000 50,000
EPS Rs.5.20 Rs.0.30
Preferred Stock Alternative

45. 0 100 200 300 400 500 600 700
EBIT-EPS Chart
EBIT (Rs. thousands)
EarningsperShare(Rs.)
0
1
2
3
4
5
6
Common
Debt
Indifference point
between preferred
stock and common
stock financing
Preferred

46. Risk Interpretation
0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
EarningsperShare(Rs.)
0
1
2
3
4
5
6
Common
Debt
Lower risk. Only a small
probability that EPS will
be less if the debt
alternative is chosen.
ProbabilityofOccurrence
(fortheprobabilitydistribution)

47. 0 100 200 300 400 500 600 700
EBIT (Rs. thousands)
EarningsperShare(Rs.)
0
1
2
3
4
5
6
Common
Debt
Higher risk. A much larger
probability that EPS will
be less if the debt
alternative is chosen.
ProbabilityofOccurrence
(fortheprobabilitydistribution)

48. Variability of EPS
 Preferred stock financing will lead to the
greatest variability in earnings per share
based on the DFL.
 This is due to the tax deductibility of
interest on debt financing.
DFLEquity = 1.00
DFLDebt = 1.25
DFLPreferred = 1.35
Which financing
method will have the
greatest relative
variability in EPS?

49. Financial Risk
 Debt increases the probability of cash insolvency
over an all-equity-financed firm. For example, our
example firm must have EBIT of at least Rs.100,000
to cover the interest payment.
 Debt also increased the variability in EPS as the DFL
increased from 1.00 to 1.25.
Financial Risk -- The added variability in earnings per
share (EPS) -- plus the risk of possible insolvency -- that
is induced by the use of financial leverage.

50. Appropriate Amount of Financial Leverage?
 Firms must first analyze their expected future cash
flows.
 The greater and more stable the expected future cash
flows, the greater the debt capacity.
 Fixed charges include: debt principal and interest
payments, lease payments, and preferred stock
dividends.
Debt Capacity -- The maximum amount of debt (and
other fixed-charge financing) that a firm can adequately
service.

51.  Based on the following information on Levered
Company, answer these questions:
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?
Sample problem

52. Levered Company
Sales (100,000 units) Rs. 1,400,000
Variable Costs Rs. 800,000
Fixed Costs Rs. 250,000
Interest paid Rs. 125,000
Tax rate 34%
Common shares outstanding 100,000

53. Sales
EBITEPS
DOL
DFL
DCL
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. Degree of Financial Leverage
DFL = EBIT
EBIT - I
= 350,000
225,000
= 1.556

56. Degree of Combined Leverage
DCL = Sales - Variable Costs
EBIT - I
1,400,000 - 800,000
225,000
= 2.667
=

57. Levered Company
Sales
EBITEPS
DOL = 1.714
DFL =
1.556
DCL =2.667

58. Levered Company 10% increase in sales
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 Rs. 1.881 ( +26.67%)

59. Coverage Ratios
Interest Coverage
EBIT
Interest expenses
Indicates a firm’s ability
to cover interest
charges.
Income Statement
Ratios
Coverage Ratios
A ratio value equal to 1
indicates that earnings
are just sufficient to
cover interest charges.

60. Coverage Ratios
Debt-service Coverage
EBIT
{ Interest expenses + [Principal
payments / (1-t) ] }
Indicates a firm’s ability to
cover interest expenses
and principal payments.
Income Statement
Ratios
Coverage Ratios
Allows us to examine the
ability of the firm to meet
all of its debt payments.
Failure to make principal
payments is also default.

61. Coverage Example
Make an examination of the coverage ratios
for Basket Wonders when EBIT=Rs.500,000.
Compare the equity and the debt financing
alternatives.
Assume that:
Interest expenses remain at Rs.100,000
Principal payments of Rs.100,000 are made
yearly for 10 years

62. Coverage Example
Compare the interest coverage and debt burden
ratios for equity and debt financing.
Interest Debt-service
Financing Coverage Coverage
Equity Infinite Infinite
Debt 5.00 2.50
The firm actually has greater risk than the interest coverage
ratio initially suggests.

63. Coverage Example
-250 0 250 500 750 1,000 1,2
EBIT (Rs. thousands)
Firm B has a much
smaller probability
of failing to meet its
obligations than Firm A.
Firm B
Firm A
Debt-service burden
= Rs.200,000
PROBABILITYOFOCCURRENCE

64. Summary of the Coverage
Ratio Discussion
 A single ratio value cannot be interpreted
identically for all firms as some firms have
greater debt capacity.
 Annual financial lease payments should be
added to both the numerator and denominator
of the debt-service coverage ratio as financial
leases are similar to debt.
 The debt-service coverage ratio accounts for
required annual principal payments.