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