The document covers the concepts of operating and financial leverage, detailing how businesses can use these strategies to maximize profits while managing risks. It includes discussions on break-even analysis, the implications of fixed and variable costs, and the calculations related to degrees of operating and financial leverage. Additionally, it addresses the potential downsides of excessive leverage and when it is advisable for firms to adopt conservative approaches.

1. Topic 02
• Operating and Financial Leverage
5-1

2. Chapter Outline
• What is leverage?
• Break-even analysis
• Operating leverage
• Financial leverage
• Combined leverage
• Potential profits or increased risk?
5-2

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. 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. 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. Break-Even Chart: Leveraged Firm
5-6

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 Income
Costs (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. 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. Volume-Cost-Profit Analysis:
Leveraged Firm
5-9

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. Break-Even Chart:
Conservative Firm
5-11

12. Volume-Cost-Profit Analysis:
Conservative Firm
5-12

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. 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. 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. Operating Income or Loss
5-16

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. Algebraic Formula for DOL
DOL = Q (P – VC)
Q (P – VC) – FC
Where,
• 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 - $60,000
i.e. DOL = 2.7
5-18

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. Nonlinear Break-Even Analysis
5-20

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. 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. Impact of Financing Plan on
Earnings per Share
5-23

24. Financing Plans and Earnings
per Share
5-24

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. 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. 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. Combined Leverage Influence
on the Income Statement
5-28

29. Combining Operating
and Financial Leverage
5-29

30. Operating and Financial
Leverage
5-30

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% = 4
Percent change in sales $40,000 X 100 25%
$160,000
5-31

32. Degree of Combined Leverage
(cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From 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) - $72,000
DCL = $96,000 = $96,000 = 4
$96,000 - $72,000 $24,000
5-32

33. END
5-33

34. Q&A
5-34

35. Thank You.
5-35