Ch16
Operating
and Financial
Leverage
Cost Structure and
Dividend Decision
Prepared by:
Chara Charalambous
CDA COLLEGE
Chara Charalambous
Chapter 16 - Outline
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What is Leverage?
Break-Even Analysis
Operating Leverage
Risk Analysis of Leverage
Financial Leverage
Indifference Point
Combined or Total Leverage
Summary and Conclusions
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Learning Objectives
1. Define leverage as a method to magnify
earnings available to the firm’s common
shareholders. (LO1)
2. Define and calculate operating leverage
and assess its opportunities and
limitations. (LO2)
3. Define and calculate financial leverage
and assess its opportunities and
limitations. (LO3)
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Learning Objectives
4. Calculate the indifference point between
financing plans using EBIT/EPS analysis.
(LO4)
5. Define and calculate combined leverage.
(LO5)
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LO1
Break-Even Analysis
• A firm’s operational costs may be classified
as:
-- fixed: those costs that remain the same in the short
run (e.g.: rental, amortization, executive salaries,
property taxes)
-- variable: those costs that change as
production/sales changes (e.g. raw material,
factory labour, sales commissions)
-- semi variable: those costs that may change but not
directly related to production/sales (e.g. utilities,
repairs and maintenance)
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LO2
Break-Even Analysis
• Break-even analysis is the technique used to study the
effect of sales volume on costs and profit.
• The interesting sales volume is the break-even (BE)
sales level, at which a firm’s total revenue equals total
cost, that is, the firm does not make money nor lose
money (breaks even)
• Mathematically,
Fixed costs
FC
FC
BE 


Contribution margin P  VC CM
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Break even point is the number of units sold at
which the company has neither profit nor loss but it
just covers all of its costs.
Two methods to compute Break-even-point:
A) The equation method
and
B) The contribution margin method
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A) The equation method:
Profit= Sales – variable costs – fixed costs
Sales= Profits + variable costs +fixed costs
Example: The A company is selling one unit of its product for €250. it
therefore
has variable expenses €150 per unit and total fixed expenses €35000.
What is the level of sales at which it has break even?
Q*250=Q*150+35000+0 =>Q*250-Q*150=35000
=>100Q=35000 =>Q=350 total units
So the break even in total euro sales is 350*250= €87500
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B) The contribution margin method:
Is based on the idea show at the beginning where:each
unit sold gives a certain amount of contribution margin
that goes toward covering fixed costs.
Break-even-point = Fixed Expenses
Contribution margin per unit
Example 1 slide 11: BEP=35000=350 units
100
If we wish to find the BEP in total euro sales, which is
useful for companies that have multiple product lines
and they want to compute a single break even point for
the company as a whole, we use the following
Calculation: Break-even-point = Fixed Expenses
CM Ratio
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• Summary :
A firm is less exposed to downturns if It has lower fixed
expenses, lower break even sales (75000 instead of
85714) . It will not incur losses as quickly as other firms
with higher BEP and higher FC in periods where sales
decline a lot.
Thus the firm’s income is less unstable. On the one
hand this is a disadvantage in cases of sales increase
but it provides more protection when sales drop.
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LO2
Table -2
Volume-cost-profit analysis: leveraged
firm
Total
Units Variable
Sold
Costs
0
20,000
40,000
50,000
60,000
80,000
Fixed
Costs
Total
Costs
Operating
Total
Income
Revenue
(loss)
0
16,000
32,000
40,000
48,000
64,000
$60,000
60,000
60,000
60,000
60,000
60,000
$ 60,000
0 $(60,000)
76,000 $ 40,000 (36,000)
92,000
80,000
(12,000)
100,000 100,000
0
108,000 120,000
12,000
124,000 160,000
36,000
100,000 80,000
60,000
140,000
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200,000
60,000
LO2
FIGURE 1
Break-even chart:
Leveraged firm
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LO2
Table 3
Volume-cost-profit analysis:
conservative firm
Total
Units Variable
Sold
Costs
0
0
20,000 $ 32,000
30,000 48,000
40,000 64,000
60,000 96,000
80,000 128,000
100,000 160,000
Fixed
Costs
Total
Costs
$12,000 $ 12,000
12,000
12,000
12,000
12,000
12,000
12,000
Operating
Total
Income
Revenue
(loss)
0
$(12,000)
44,000 $ 40,000
60,000
60,000
76,000
80,000
108,000 120,000
140,000 160,000
172,000 200,000
(4,000)
0
4,000
12,000
20,000
28,000
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LO2
FIGURE 2
Break-even chart:
Conservative firm
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Conclusion: Without knowing the future it is not obvious
which cost structure is better. Both have advantages and
disadvantages.
• A company with higher fixed cost and lower variable costs will
experience wider changes in net profit as changes take
place in sales: great profits in good years, great losses in bad
years.
• A company with lower fixed costs and higher variable costs
will enjoy grater stability in net profit and will be more
protected from losses in bad years but it will have lower
profits in good years.
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Operating Leverage
A lever is a tool for multiplying force.
Using a lever, a massive object can be moved with
only an ordinary amount of force.
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LO1
What is Leverage?
Leverage is using fixed costs to magnify
the potential return to a firm
Magnify= enlarge, expand, increase, zoom
2 types of fixed costs:
1. fixed operating costs = rent, depreciation e.t.c
2. fixed financial costs = interest costs from debt
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Why?
Operating Leverage: The use of
fixed operating costs by the firm.
• 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)
• As sales increases fixed costs remain the same so we
have more profits. Variable costs do not serve this
purpose because they increase as sales increases.
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Operating Leverage
A lever is a tool for multiplying force (acts as a
multiplier).
Using a lever, a massive object can be moved
with only an ordinary amount of force.
In business, operating leverage serves a similar
purpose.
• If operating leverage is high, a small percentage
increase in sales can produce a much larger
percentage increase in net operating income.
• Operating leverage is a measure of how
sensitive net profit is to a given percentage
change in euro sales
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LO1
What is Leverage?
2 types of leverage:
1.
2.
Operating Leverage = the extent to which fixed assets and associated
fixed costs are utilize
Financial Leverage = the amount of debt used in the capital structure
(debt/equity mix)
Assets
Fixed Assets
Balance Sheet___________________
Equity
Equity (Shares)
(capital assets)
Liabilities
Operating
Leverage Current Assets
(interest charges) Financial
Debt (Loans,
bonds, leases)
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Leverage
LO1
Table 1
Income statement
Sales (total revenue) (80,000 units @ $2) $160,000
— Variable costs ($0.80 per unit)
64,000
Contribution margin
96,000
— Fixed costs
60,000
Operating income
36,000
Earnings before interest and taxes
36,000
— Interest Expense
12,000
Earnings before taxes
24,000
— Taxes
12,000
Earnings aftertaxes
$ 12,000
Shares
8,000
Earnings per share
$1.50
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Operating
leverage
Financial
leverage
3 ways to calculate DOL
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©2009 McGraw-Hill Ryerson Limited
1. The Degree of operating leverage at a given
level of sales is computed by the following formula:
(if the company we study sells more than one product : is a
multiproduct firm)
Degree of operating leverage = Contribution Margin
at $ dollars of sales
Net Operating Income (EBIT)
OR DOL
=
at $ dollars of sales
EBIT + FC
EBIT
(is the same thing as above)
– The degree of operating leverage is a measure, at a
given level of sales, of how percentage change in
sales volume will affect profits.
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2. Percentage change in Operating Income
( EBIT ) for a given percentage in Sales:
•
DOL at Q units of output (or sales)=
% Δ EBIT
% Δ Sales
• The sensitivity of the firm to a change in sales as
measured by DOL will be different at each level of output
(or sales). Therefore, we always need to indicate the
level of output (or sales) at which DOL is measured – as
in DOL at Q units.
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• 3. Quantity Method
• DOL
=
Q
at Q units of output (or s ales)
Q – QBE
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(if single product company)
The answer given to us, what ever
method we use ,is:
Degree of operating leverage (DOL): The
percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
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• Question: What does “DOL5,000 units = 5”
really mean?
• Answer: It means that a 1 percent change in
sales from the 5,000-unit sales position causes a
5 percent change in EBIT. In fact, any
percentage change in sales from the 5,000-unit
position causes a percentage change in EBIT
that is five times as large.
• For example, a 3 percent decrease in sales
causes a 15 percent decrease in EBIT, and a 4
percent increase in sales causes a 20 percent
increase in EBIT.
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• Question: How would knowledge of a firm’s
DOL be of use to a financial manager?
• Answer: The manager would know in advance
what impact a potential change in sales would have
on operating profit. Sometimes, in response to this
advance knowledge, the firm may decide to make
some changes in its sales policy and/or cost
structure. As a general rule, firms do not like to
operate under conditions of a high degree of
operating leverage because, in that situation, a
small drop in sales may lead to an operating loss.
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Distinguish between operating leverage and financial
leverage.
• Both operating and financial leverage result in the
magnification (enlargement) of changes to earnings due
to the presence of fixed costs in a company's cost
structure. The difference is only the part of the income
statement we are looking at. Operating leverage is the
magnification on the top half of the income statement how EBIT changes in response to changes in sales; the
relevant fixed cost is the fixed cost of operating the
business. Financial leverage is the magnification on the
bottom half of the income statement - how earnings per
share changes in response to changes in EBIT; the
relevant fixed cost is the fixed cost of financing, in
particular interest.
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• No fixed financing costs. A firm with no fixed
financing costs has no financial leverage. In
such a firm, earnings per share will rise and fall
with EBIT by the same percentage.
For
example, a 15% increase in EBIT will result in a
15% increase in EPS; a 9% decrease in EBIT
will result in a 9% decrease in EPS.
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The Effect of Financial Leverage: How does leverage
affect the EPS of a firm?
• When we increase the amount of debt financing, we
increase the fixed interest expense
• If we have a really good year, then we pay our fixed
cost and we have more left over for our stockholders
• If we have a really bad year, we still have to pay our fixed
costs (same amount as above point) and we have less
left over for our stockholder
• Leverage magnifies the variation in EPS
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LO2
Risk Analysis of Leverage
• A leveraged firm has high fixed costs,
a high BE point and high DOL.
• A non-leveraged firm has low fixed
costs, a low BE point and low DOL.
• Leverage is a double-edged sword.
It magnifies losses as well as profits.
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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.
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LO3
Financial Leverage
• Measure of the amount of debt used by a firm
• Degree of Financial Leverage (DFL) =
%age  in EPS
%age  in EBIT (or OI)
• a  in EBIT (or OI)  a larger  in EPS if
DFL > 1
• DFL measures the sensitivity of a firm’s
earnings per share to a  in operating income.
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LO4
TABLE 4
Impact of financing
plan on earnings
per share
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LO4
Indifference Point
• the level of EBIT at which alternative financing plans
yield the same earnings per share (EPS)
• Mathematically,
SB  I A  S A  I B
EBIT * 
SB  S A
(24,000  $12,000)  (8,000  $4,000)
EBIT * 
 $16,000
24,000  8,000
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The break-even point is the EBIT level
where EPS is the same for two (or more)
alternatives.
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LO4
Figure 3
Financial leverage in selected industries
Total debt / equity
Long-term debt / equity
3.00
2.50
Ratio
2.00
1.50
1.00
0.50
Al
li
nd
us
Al
tri
ln
es
on
fin
an
ci
al
Ag
ri c
ul
tu
O
re
il
an
d
G
as
M
in
im
g
U
til
itie
C
on
s
st
ru
ct
M
io
an
n
uf
ac
tu
rin
R
g
ea
l
Ac
es
ta
co
te
m
m
od
at
io
n
0.00
Source: Statistics Canada, “Quarterly Financial Statistics for Enterprises”, Catalogue 61-008-X, First quarter, 2008
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LO5
Combined or Total Leverage
• Represents maximum use of leverage
• Degree of Combined Leverage (DCL ) =
%age  in EPS
%age  in Sales
• a  in Sales  a larger  in EPS if DCL > 1
• Short-cut formula:
DCL or DTL = DOL x DFL
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LO5
Table 5
Operating and financial leverage
(Taken from Table 5-6)
(80,000 units)
Sales — $2 per unit
— Variable costs ($0.80 per unit)
Contribution margin
— Fixed costs
Operating income (EBIT)
— Interest
Earnings before taxes
— Taxes
Earnings after taxes
Shares
Earnings per share
$160,000
64,000
$96,000
60,000
36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
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(100,000 units)
$200,000
80,000
$120,000
60,000
60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
LO2/LO3/LO4
Formula Review
Fixed costs
FC
FC
BE 


Contribution margin P  VC CM
CM
DOL 
EBIT
EBIT
DFL 
EBT
EBIT * 
S  I  S  I 
B
A
S S
B
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A
A
DCL = DOL × DFL
B
Summary and Conclusions
• Leverage refers to the use of fixed costs to
magnify the profits (or losses) of a firm
• It is a double-edged sword-tool.. Management
must be sure of the level of risk assumed
• Operating leverage refers to using fixed
operating costs, such as lease or amortization
expense
• The degree of operating leverage (DOL)
measures the %age change in operating income
as a result of a %age change in sales
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Summary and Conclusions
• Financial leverage refers to the fixed financing
charge such as interest cost on debt
• The degree of financial leverage (DFL)
measures the %age change in earnings per
share (EPS) as a result of a %age change in
operating income
• The higher the level of fixed costs (both
operating and financing costs), the greater the
effect on net income of an increase in sales
revenue (This is the degree of combined
leverage (DCL))
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