CHAPTER
FIVE
Operating and
Financial Leverage
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Figure 5-1
Break-even chart: Leveraged firm
Total
Revenue
Revenues and costs ($ thousands)
200
Profit
160
120
100
80
60
40
BE
Variable costs
Loss
20
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Total
costs
Fixed
costs
40
50
60
80
100
120
Units produced and sold (thousands)
Fixed costs ($60,000)
Price ($2) Variable costs per unit ($0.80)
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Table 5-2
Volume-cost-profit analysis: Leveraged firm
Units
Sold
Total
Variable
Costs
0
0
20,000 $16,000
40,000 32,000
50,000 40,000
60,000 48,000
80,000 64,000
100,000 80,000
Fixed
Costs
$ 60,000
60,000
60,000
60,000
60,000
60,000
60,000
Total
Costs
$ 60,000
76,000
92,000
100,000
108,000
124,000
140,000
Total
Revenue
0
$ 40,000
80,000
100,000
120,000
160,000
200,000
Operating
Income
(loss)
$ (60,000)
(36,000)
(12,000)
0
12,000
36,000
60,000
Block
Hirt
Short
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Figure 5-2
Break-even chart: Conservative firm
Total
Revenue
Revenues and costs ($ thousands)
200
Profit
Total
costs
160
120
80
40
BE
20
Loss
Block
Hirt
Short
Variable costs
40
60
80
100
120
Fixed
costs
Units produced and sold (thousands)
Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)
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Table 5-3
Volume-cost-profit analysis: Conservative firm
Units
Sold
0
20,000
30,000
40,000
60,000
80,000
100,000
Total
Variable
Costs
0
$ 32,000
48,000
64,000
96,000
128,000
160,000
Fixed
Costs
Total
Costs
$ 12,000
$12,000
12,000
12,000
12,000
12,000
12,000
12,000
44,000
60,000
76,000
108,000
140,000
172,000
Operating
Total
Income
Revenue
(loss)
0
$ 40,000
60,000
80,000
120,000
160,000
200,000
$ (12,000)
(4,000)
0
4,000
12,000
20,000
28,000
.
.
Block
Hirt
Short
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Table 5-4
Operating income or loss
Leveraged
Firm
(Table 5-2)
Units
0
20,000
40,000
60,000
80,000
100,000
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
$(60,000)
(36,000)
(12,000)
12,000
36,000
60,000
Conservative
Firm
(Table 5-3)
$(12,000)
(4,000)
4,000
12,000
20,000
28,000
Block
Hirt
Short
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Figure 5-3
Nonlinear break-even analysis
Revenue
weakness
Revenues and costs ($ thousands)
200
160
Total
revenue
Cost
overruns
120
80
Total
costs
40
120
Block
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Short
20
40 area 60
Valid
80
100
Units (thousands)
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Table 5-5a
Impact of financing plan on earnings per share
Plan A
(leveraged)
Block
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PPT 5-7
1. EBIT (0)
Earnings before interest and taxes (EBIT)
— Interest (I)
Earnings before taxes (EBT)
— Taxes (T) *
Earnings aftertaxes(EAT)
Shares
Earnings per share (EPS)
2. EBIT ($12,000)
Earnings before interest and taxes (EBIT)
— Interest (I)
Earnings before taxes (EBT)
— Taxes (T)
Earnings aftertaxes (EAT)
Shares
Earnings per share (EPS)
Plan B
(conservative)
0
$(12,000)
(12,000)
(6,000)
$ (6,000)
8,000
$ (0.75)
$ (4,000)
(4,000)
(2,000)
$ (2,000)
24,000
$ (0.08)
$12,000
12,000
0
0
$
0
8,000
0
$12,000
4,000
8,000
4,000
$ 4,000
24,000
$0.17
.
.
.
.
0
.
.
.
.
* The assumption is that large losses can be written off against other income, perhaps in other years,
thus providing the firm with a tax savings benefit. The tax rate is 50 percent for ease of computation.
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Table 5-5b
Impact of financing plan on earnings per share
Plan A
(leveraged)
Plan B
(conservative)
3. EBIT ($16,000)
Earnings before interest and taxes (EBIT)
— Interest (I)
Earnings before taxes (EBT)
— Taxes (T)
Earnings aftertaxes (EAT)
Shares
Earnings per share (EPS)
$ 16,000
12,000
4,000
2,000
$ 2,000
8,000
$0.25
$ 16,000
4,000
12,000
6,000
$ 6,000
24,000
$0.25
4. EBIT ($36,000)
Earnings before interest and taxes (EBIT)
— Interest (I)
Earnings before taxes (EBT)
— Taxes (T)
Earnings aftertaxes (EAT)
Shares
Earnings per share (EPS)
$ 36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
$ 36,000
4,000
32,000
16,000
$ 16,000
24,000
$0.67
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Table 5-5c
Impact of financing plan on earnings per share
5. EBIT ($60,000)
Earnings before interest and taxes (EBIT)
— Interest (I)
Earnings before taxes (EBT)
— Taxes (T)
Earnings aftertaxes (EAT)
Shares
Earnings per share (EPS)
Plan A
(leveraged)
Plan B
(conservative)
$ 60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
$ 60,000
4,000
56,000
28,000
$ 28,000
24,000
$ 1.17
Block
Hirt
Short
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Figure 5-4
Financing plans and earnings per share
EPS ($)
4
Plan A
3
2
Plan B
1
.25
0
-1
Block
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-2
0
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12
16
25
50
75
EBIT ($ thousands)
100
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Figure 5-5
Financial leverage in selected industries (third quarter, 1998)
Total debt / equity
Long-term debt / equity
8.00
7.00
Ratio
6.00
5.00
4.00
3.00
2.00
Tele communications
Re al estate
Electronics,
computers
Motor vehicles
Machinery,
equipment
Chemical, te xtile s
Pe trole um, natural
gas
Wood, paper
Food
Beve rage, tobacco
Block
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All nonfinancial
0.00
All industries
1.00
Source : Sta tistics Ca na da , Quarte rly Financia l S ta tistics for Ente rprise s, Ca talogue 61-008
XPB, third qua rte r, 1998.
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Table 5-6
Income statement
Sales (total revenue) (80,000 units @ $2)
— Fixed costs
— Variable costs ($0.80 per unit)
Operating income
Earnings before interest and taxes
— Interest
Earnings before taxes
— Taxes
Earnings aftertaxes
Shares
Earnings per share
$160,000
60,000
64,000
$ 36,000
$ 36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
Operating
leverage
Financial
leverage
Block
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Short
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Figure 5-6
Combining operating and financial leverage
$
Earnings generated
EPS =
$1.50
Financial
leverage
Operating income = EBIT
$36,000
$36,000
Operating
leverage
Block
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Sales =
$160,000
Leverage impact
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Table 5-7
Operating and financial leverage
(Taken from Table 5-6)
(80,000 units)
Sales — $2 per unit
— Fixed costs
— Variable costs ($0.80 per unit)
Operating income (EBIT)
— Interest
Earnings before taxes
— Taxes
Earnings aftertaxes
Shares
Earnings per share
$160,000
60,000
64,000
36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
(100,000 units)
$200,000
60,000
80,000
60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
Block
Hirt
Short
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Chapter 5 - Outline
LT 5-1
• What is Leverage?
• Operating Leverage
• Financial Leverage
• Leverage Means Risk
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• Combined or Total Leverage
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What is Leverage?
LT 5-2
Leverage is using fixed costs to magnify the potential
return to a firm
2 types of fixed costs:
– fixed operating costs = rent, amortization
– fixed financial costs = interest costs from debt
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Operating Leverage
LT 5-3
• Measure of the amount of fixed operating costs used by a
firm
• Operating Leverage measures the sensitivity of a firm’s
operating income to a ∆ in sales
• a ∆ in Sales → a larger ∆ in EBIT (or OI)
Block
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• Degree of Operating Leverage (DOL)
= %age ∆ in EBIT ( or OI)
%age ∆ in Sales
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Financial Leverage
LT 5-4
• Measure of the amount of debt used and interest paid by a
firm
• Financial Leverage measures the sensitivity of a firm’s
earnings per share to a ∆ in operating income
• a ∆ in EBIT (or OI) → a larger ∆ in EPS
Block
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• Degree of Financial Leverage (DFL)
= %age ∆ in EPS
%age ∆ in EBIT (or OI)
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Leverage Means Risk
LT 5-5
• Leverage is a double-edged sword
• It magnifies losses as well as profits
• An aggressive or highly leveraged firm has a relatively
high break-even point (and high fixed costs)
• A conservative or non-leveraged firm has a relatively low
break-even point (and low fixed costs)
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Combined or Total Leverage
LT 5-6
• Represents maximum use of leverage
• a ∆ in Sales → a larger ∆ in EPS
• Degree of Combined Leverage (DCL ) = %age ∆ in EPS
%age ∆ in Sales
• Short-cut formula:
DCL = DOL x DFL
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