This document discusses operating and financial leverage. It defines operating leverage as the use of fixed operating costs, which can increase sensitivity to sales changes. Financial leverage refers to the use of fixed financing costs. The document explains how to calculate break-even points, degree of operating leverage, and degree of financial leverage. It also shows how financing choices like debt, equity or preferred stock affect earnings per share through an EBIT-EPS analysis.

1. Chapter 16 Operating and Financial Leverage © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

23. Interpretation of the DOL 2,000 4,000 6,000 8,000 1 2 3 4 5 QUANTITY PRODUCED AND SOLD 0 -1 -2 -3 -4 -5 DEGREE OF OPERATING LEVERAGE (DOL) Q BE

29. Application of DOL for Our Three-Firm Example The ranked results indicate that the firm most sensitive to the presence of operating leverage is Firm F . Firm F DOL = 8.0 Firm V DOL = 6.6 Firm 2F DOL = 2.0 Firm F will expect a 400% increase in profit from a 50% increase in sales (see Slide 16-7 results).

34. EBIT-EPS Chart 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 0 1 2 3 4 5 6 Common

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

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

39. What About Risk? 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 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. Probability of Occurrence (for the probability distribution)

40. What About Risk? 0 100 200 300 400 500 600 700 EBIT ($ thousands) Earnings per Share ($) 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. Probability of Occurrence (for the probability distribution)

54. Risk versus Return Compare the expected EPS to the DTL for the common stock equity financing approach to the debt financing approach. Financing E(EPS) DTL Equity $3.50 1.20 Debt $5.60 1.50 Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)!

59. 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.

60. Coverage Example -250 0 250 500 750 1,000 1,250 EBIT ($ thousands) Firm B has a much smaller probability of failing to meet its obligations than Firm A. Firm B Firm A Debt-service burden = $200,000 PROBABILITY OF OCCURRENCE