Chapter 5
Operating and
Financial Leverage
McGraw-Hill/Irwin
5-1
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
Operating Income
Costs (TVC)
(FC)
(loss)
(50,000 X $0.80)
$40,000
$60,000
0
Total Costs
Total Revenue
(TC)
(TR)
$100,000
(50,000 X $2)
$100,000
5-7
Break-Even Analysis (cont’d)
• The break-even point can also be calculated by:
Fixed costs
=
Contribution margin
i.e.
Fixed costs
=
Price – Variable cost per unit
FC
P – VC
$60,000
= $60,000 = 50,000 units
$2.00 - $0.80
$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 = $8,000 X 100
Percent change in unit volume
$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
Plan A (leveraged)
Debt (8% interest) $150,000 ($12,000 interest)
Common stock
50,000 (8000 shares at $6.25)
Total financing
$200,000
Plan B (conservative)
$ 50,000 ($4,000 interest)
150,000 (24,000 shares at $6.25)
$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 bottomline 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
$1.50
Percent change in sales $40,000 X 100
$160,000
= 100% = 4
25%
=
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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.
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 = 4
$96,000 – $72,000 $24,000
DCL =
5-32