• Operating Leverage
• Financial Leverage
1
Business Risk
• The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT
FIRM
EPS
Stockholders
2
Business Risk
Affected by:
• Sales volume variability
• Competition
• Cost variability
• Product diversification
• Product demand
• Operating Leverage
3
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.
4
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
5
Financial Leverage
• The use of fixed-cost sources of
financing (debt, preferred stock)
rather than variable-cost sources
(common stock).
• A firm with relatively high fixed
financing costs will experience
more net income if EBIT changes.
6
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).
7
Operating Leverage
• What happens if the firm increases
its fixed operating costs and reduces
(or eliminates) its variable costs?
8
With high operating leverage,
an increase in sales
produces a relatively larger
increase in operating
income.
9
Trade-off:
the firm has
a higher breakeven
point. If sales are not
high enough, the firm
will not meet its fixed
expenses!
10
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.
11
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.
12
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.
13
Degree of Operating Leverage
from Sales Level (S)
DOLs =
=
=
% change in EBIT
% change in sales
Sales - Variable Costs
EBIT
Q(P - V)
Q(P - V) - F
14
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
15
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.
16
Degree of Financial Leverage
% change in EPS
% change in EBIT
DFL =
=
EBIT
EBIT - I
17
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
18
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.
19
Degree of Combined Leverage
DCL = DOL x DFL
% change in EPS
=
% change in Sales
=
=
Sales - Variable Costs
EBIT - I
Q(P - V)
Q(P - V) - F - I
20
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
21
In-class Project:
• Based on the following information on
Levered Company, answer these
questions:
1) If sales increase by 1%, what should
happen to operating income?
2) If operating income increases by 1%,
what should happen to EPS?
3) If sales increase by 1%, what should be
the effect on EPS?
22
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
23
Leverage
Sales
DCL
EPS
DOL
DFL
EBIT
24
Degree of Operating Leverage
from Sales Level (S)
Sales - Variable Costs
DOLs =
EBIT
=
1,400,000 - 800,000
350,000
= 1.714
25
Levered Company
Sales
DCL
EPS
DOL = 1.714
DFL =
EBIT
26
Degree of Financial Leverage
EBIT
DFL =
EBIT - I
=
350,000
225,000
= 1.556
27
Levered Company
Sales
DCL
EPS
DOL = 1.714
DFL =
1.556
EBIT
28
Degree of Combined Leverage
DCL =
=
Sales - Variable Costs
EBIT - I
1,400,000 - 800,000
225,000
= 2.667
29
Levered Company
Sales
DCL
=
2.667
EPS
DFL =
1.556
DOL = 1.714
EBIT
30
Levered Company
1% increase in sales
Sales (110,000 units)
Variable Costs
Fixed Costs
EBIT
Interest
EBT
Taxes (34%)
Net Income
EPS
1,414,000
(808,000)
(250,000)
356,000 ( +1.714%)
(125,000)
231,000
(78,540)
152,460
$1.5246 ( +2.667%)
31