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%)