Chapter O P E R AT I N G McGraw-Hill/Irwin A N D 5 F I N A N C I A L L E V E R A G E Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER OUTLINE • What is leverage? • Break-even analysis • Operating leverage • Financial leverage • Combined leverage • Potential profits or increased risk? 5-2 WHAT IS LEVERAGE? • Use of special forces and effects to magnify or produce more than 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 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 minimizes risk exposure 5-4 OPERATING LEVERAGE • Extent to which fixed assets and associated fixed costs are utilized in a business • Operational costs include: – Fixed – Variable – Semivariable 5-5 BREAK-EVEN CHART: LEVERAGED FIRM 5-6 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 Costs (TVC) (FC) Total Costs (TC) (50,000 X $0.80) $40,000 Total Revenue Operating Income (TR) (loss) (50,000 X $2) $60,000 $100,000 $100,000 0 5-7 BREAK-EVEN ANALYSIS (CONT’D) • The break-even point can also be calculated by: Fixed costs Contribution margin i.e. $60,000 $2.00 - $0.80 = Fixed costs = Price – Variable cost per unit FC P – VC = $60,000 = 50,000 units $1.20 5-8 VOLUME-COST-PROFIT ANALYSIS: LEVERAGED FIRM Table 5-2 5-9 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 BREAK-EVEN CHART: CONSERVATIVE FIRM 5-11 VOLUME-COST-PROFIT ANALYSIS: CONSERVATIVE FIRM Table 5-3 5-12 THE RISK FACTOR • Factors influencing decision on maintaining a conservative or leveraged position 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 CASH BREAK-EVEN ANALYSIS • Deals with cash flows rather than accounting flows • Helps in analyzing the short-term outlook of a firm • Examples of noncash items that are excluded: – Depreciation – Credit sales – Credit purchase of materials 5-14 DEGREE OF OPERATING LEVERAGE (DOL) • Percentage change in operating income as a result of a percentage change in units sold • Computed only over a profitable range of operations • More when it is computed closer to BEP DOL = Percent change in operating income Percent change in unit volume 5-15 OPERATING INCOME OR LOSS 5-16 COMPUTATION OF DOL • Leveraged firm: DOL = Percent change in operating income = Percent change in unit volume = $24,000 X 100 $36,000 20,000 X 100 80,000 67% = 2.7 25% • Conservative firm: DOL = Percent change in operating income = Percent change in unit volume = $8,000 X 100 $20,000 20,000 X 100 80,000 40% = 1.6 25% 5-17 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 DOL = 2.7 5-18 LIMITATIONS OF ANALYSIS • Assumption of existence of constant or linear function for revenues and costs as volume changes – May not hold good in real world • Price weakening to capture increasing market • Cost overruns when moved beyond optimum-size operation – Relationships are not so fixed as assumed 5-19 NONLINEAR BREAK-EVEN ANALYSIS • Assumption of exact linear relation does not hold good in reality 5-20 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 Operating leverage Liabilities and Net Worth Financial leverage 5-21 IMPACT ON EARNINGS • Examine two financial plans for a firm, where $200,000 is required to carry the assets Total Assets = $200,000 Debt (8% interest) Common stock Plan A (leveraged) $150,000 ($12,000 interest) 50,000 (8000 shares at $6.25) Plan B (conservative) $ 50,000 ($4,000 interest) 150,000 (24,000 shares at $6.25) Total financing $200,000 $200,000 5-22 IMPACT OF FINANCING PLAN ON EARNINGS PER SHARE Table 5-5 5-23 FINANCING PLANS AND EARNINGS PER SHARE 5-24 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 • DFL for two plans can be calculated using values from Table 5-5 – 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 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 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 COMBINED LEVERAGE INFLUENCE ON THE INCOME STATEMENT • Last item under operating leverage, operating income, becomes the initial item for determining financial leverage • “Operating income” and “Earnings before interest and taxes” are one and the same, representing the return to the owners before interest and taxes are paid 5-28 COMBINING OPERATING AND FINANCIAL LEVERAGE 5-29 OPERATING AND FINANCIAL LEVERAGE Table 5-7 5-30 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 = 100% = 4 = $1.50 Percent change in sales $40,000 X 100 25% $160,000 5-31 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 – $72,000 = $96,000 = 4 $24,000 5-32