Chapter 15 – Analysis and
Impact of Leverage
What is Leverage
 Company A: sales increases 2.9
percent, but net income increases
16.9 percent.
 Company B: sales decreases 3.6
percent, but net income decreases
19.4 percent.
Two concepts that enhance
our understanding of risk...
1) Operating Leverage - affects a
firm’s business risk.
2) Financial Leverage - affects a
firm’s financial risk.
Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
Business Risk
Affected by:
 Sales volume variability
 Competition
 Product diversification
 Operating leverage
 Growth prospects
 Size
Operating Leverage
 The use of fixed operating costs as
opposed to variable operating
costs.
 A firm with relatively high fixed
operating costs will experience
more variable operating income if
sales change.
Financial Risk
 The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.
EBIT
FIRM
EPS
Stockholders
Financial Leverage
 The use of fixed-cost sources of
financing (debt, preferred stock)
rather than variable-cost sources
(common stock).
Breakeven Analysis
 Illustrates the effects of operating
leverage.
 Useful for forecasting the
profitability of a firm, division, or
product line.
 Useful for analyzing the impact of
changes in fixed costs, variable
costs, and sales price.
Costs
Suppose the firm has both fixed
operating costs (administrative
salaries, insurance, rent, property
tax) and variable operating costs
(materials, labor, energy,
packaging, sales commissions).
Operating Leverage
What happens if the firm
increases its fixed operating
costs and reduces (or
eliminates) its variable costs?
Total Revenue
Total Cost
$
+
} EBIT
FC {
Breakeven
point
Q1
Quantity
Total Revenue
$
+
{
FC
}
EBIT
Total Cost
= Fixed
-
Break-even
point
Q1
Quantity
With high operating leverage,
an increase in sales
produces a relatively larger
increase in operating
income.
Breakeven Calculations
Breakeven point (units of output)
QB =
F
P-V
 QB = breakeven level of Q.
 F = total anticipated fixed costs.
 P = sales price per unit.
 V = variable cost per unit.
Breakeven Calculations
Breakeven point (sales dollars)
S* =
F
VC
1S
 S* = breakeven level of sales.
 F = total anticipated fixed costs.
 S = total sales.
 VC = total variable costs.
Degree of Operating
Leverage (DOL)
 Operating leverage: by using fixed
operating costs, a small change in
sales revenue is magnified into a
larger change in operating income.
 This “multiplier effect” is called
the degree of operating leverage.
Degree of Operating Leverage
from Sales Level (S)
DOLs =
=
% change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales
Degree of Operating Leverage
from Sales Level (S)
 If we have the data, we can use this formula:
Sales - Variable Costs
DOLs =
EBIT
=
Q(P - V)
Q(P - V) - F
What does this tell us?
 If DOL = 2, then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT).
Sales
EBIT
EPS
Stockholders
Degree of Financial
Leverage (DFL)
 Financial leverage: by using fixed
cost financing, a small change in
operating income is magnified into
a larger change in earnings per
share.
 This “multiplier effect” is called
the degree of financial leverage.
Degree of Financial Leverage
% change in EPS
% change in EBIT
DFL =
=
change in EPS
EPS
change in EBIT
EBIT
Degree of Financial Leverage
 If we have the data, we can use this
formula:
EBIT
DFL =
EBIT - I
What does this tell us?
 If DFL = 3, then a 1% increase in
operating income will result in a 3%
increase in earnings per share.
Sales
EBIT
EPS
Stockholders
Degree of Combined
Leverage (DCL)
 Combined leverage: by using operating
leverage and financial leverage, a small
change in sales is magnified into a larger
change in earnings per share.
 This “multiplier effect” is called the
degree of combined leverage.
Degree of Combined Leverage
DCL = DOL x DFL
% change in EPS
=
% change in Sales
=
change in EPS
EPS
change in Sales
Sales
Degree of Combined Leverage
 If we have the data, we can use this
formula:
DCL =
=
Sales - Variable Costs
EBIT - I
Q(P - V)
Q(P - V) - F - I
What does this tell us?
 If DCL = 4, then a 1% increase in
sales will result in a 4% increase in
earnings per share.
Sales
EBIT
EPS
Stockholders
In-class Project:
Based on the following information on
Levered Company, answer these
questions:
1) If sales increase by 10%, what should
happen to operating income?
2) If operating income increases by 10%,
what should happen to EPS?
3) If sales increase by 10%, what should be
the effect on EPS?
Levered Company
Sales (100,000 units)
Variable Costs
Fixed Costs
Interest paid
Tax rate
Common shares outstanding
$1,400,000
$800,000
$250,000
$125,000
34%
100,000
Levered Company
Sales
Operating
Income
Operating
leverage
Financial
leverage
EPS
Degree of Operating Leverage
from Sales Level (S)
Sales - Variable Costs
DOLs =
EBIT
=
1,400,000 - 800,000
350,000
= 1.714
Levered Company
17.14%
10%
Sales
Operating
Income
Operating
leverage
EPS
Degree of Financial Leverage
EBIT
DFL =
EBIT - I
=
350,000
225,000
= 1.556
Levered Company
15.56%
10%
Sales
Operating
Income
Financial
leverage
EPS
Degree of Combined Leverage
DCL =
=
Sales - Variable Costs
EBIT - I
1,400,000 - 800,000
225,000
= 2.667
Levered Company
26.67%
10%
Sales
Operating
Income
Operating
leverage
Financial
leverage
EPS
Levered Company
10% increase in sales
Sales (110,000 units)
Variable Costs
Fixed Costs
EBIT
Interest
EBT
Taxes (34%)
Net Income
EPS
1,540,000
(880,000)
(250,000)
410,000 ( +17.14%)
(125,000)
285,000
(96,900)
188,100
$1.881 ( +26.67%)