Types of Leverage Operating Leverage Fin

TYPES OF LEVERAGE
Operating Leverage
Financial Leverage
Elaborated by and for exclusive use of Ignacio

Man-Ging MBA; Finance II; GEI; UCSG.
Questions and answers

What did we talk about last class?
Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance II; GEI; UCSG.
TYPES OF LEVERAGE
OPERATING LEVERAGE
FINANCIAL LEVERAGE
Why do we need to know about

leverage?
Leverage includes risk. More leverage, more risk.
However, at the same time more risk implicates
higher returns.
LEVERAGE
Leverage exists when the company has fixed costs and
expenses. From now on well call both Fixed Costs.
Generally, increases in leverage result in increases in risk and

return, whereas decreases in leverage result in decreases in
risk and return.
More risks, we tend to expect more return (profitability). And

viceversa. No pain, no gain.
LEVERAGE
We have two types of costs (in terms of Cost Accounting:
1. Variable
2. Fixed
How to cover the costs?
- Variable costs are covered with the price
- Fixed costs must be covered somehow
- HERES WHERE WE LEVER
TYPES OF LEVERAGE
There are two types of leverage:
1.
Operating leverage
2. Financial Leverage
FIXED
COSTS
OPERATING AND FINANCIAL LEVERAGE AND THE

INCOME STATEMENT
Table 12.1 General Income Statement Format and Types
of Leverage
Source: Gitman, Principles of Managerial Finance
OPERATING LEVERAGE
Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance I; GEI; UCSG.
OPERATING LEVERAGE
It only exists when the company has fixed operating costs
This is the leverage based on operations:
We are going to cover the operating fixed costs with our operations: with our
sales.
How many units do I need to sell to cover all the costs?
Break-even point analysis: I have to find my equilibrium point of sales to

keep my business.
Since this is regarding operations, the clue number is the EBIT (also called
Operating Profit).
10
BREAK-EVEN ANALYSIS
This analysis tells us what we need to cover our burden
(our operating costs).
This tells us the equilibrium point we must reach.

From here on, we know how many units we must sell.
11
Variable cost per unit

Price unit
Fixed Costs:
= $5
= $10
CONTRIBUTION MARGIN = $5
$5 $5
$5
$5
$5
Fixed Costs = $10.000
Equilibrium:
Fixed
costs
$10.000
Fixed costs
= Units for
equilibrium
Contr. Margin
Units for eq. = 2.000
12
OPERATING LEVERAGE
Therefore our break-even point is when EBIT =
EBIT = (P x Q) - FC - (VC x Q)
13
Mini-Exercise
Cheryls Posters has fixed operating costs of $2,500, a sales
price of $10 per poster, and variable costs of $5 per poster.
Find the Operating Break Point (number of units I need to
sell to cover my variable and fixed costs).
14
OPERATING LEVERAGE
15
Exercise (Cont)
Assume that Cheryls Posters wishes to evaluate the impact of
several options:
(1) increasing fixed operating costs to $3,000,
(2) increasing the sale price per unit to $12.50,
(3) increasing the variable operating cost per unit to $7.50
(4) simultaneously implementing all three of these changes.
EBIT = (P x Q) - FC - (VC x Q)
16
Exercise (Cont)
(1) Operating BE point =
17
OPERATING LEVERAGE
18
DEGREE OF OPERATING LEVERAGE

(DOL)
There are two ways to calculate it.
This number will tell me how much my profits before
interests (EBIT) will vary depending on sales changes
DOL = Percentage change in EBIT

Percentage change in Sales
DOL at base Sales level Q =
Q X (P VC)
Q X (P VC) FC
19
LETS RETURN TO THE FIRST EXERCISE
Fixed Costs: $2.500

20
FIRST METHOD TO CALCULATE DOL

DOL = Percentage change in EBIT
Applying this equation to cases 1 and 2 in Table 12.4
yields:
Case 1: DOL =
Case 2: DOL =
21
SECOND METHOD TO CALCULATE DOL

DOL at base Sales level Q =
Q X (P VC)
Q X (P VC) FC
DOL at 1,000 units =
22
FINANCIAL LEVERAGE
23
FINANCIAL LEVERAGE
It only exists when the company has fixed financial
costs
The most common financial costs are the interests on
debt and preferred stock dividends.
24
Mini-Exercise
Chen Foods, a small Oriental food company, expects EBIT of $10,000
in the current year. It has a $20,000 bond with a 10% annual coupon
rate and an issue of 600 shares of $4 annual dividend preferred stock.
It also has 1,000 share of common stock outstanding.
The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are
$2,400 ($4/share x 600 shares).
25
Mini-Exercise (Cont)
26
DEGREE OF FINANCIAL LEVERAGE (DFL)

There are two ways to calculate it.
This number will tell me how much my profits after interests
will vary depending on changes in my EBIT
DFL = Percentage change in EPS

Percentage change in EBIT
DFL at base level EBIT =
EBIT
EBIT I [PD x 1/(1-T)]
27
FIRST METHOD TO CALCULATE DFL

DFL = Percentage change in EPS
Percentage change in EBIT
Applying this equation to cases 1 and 2:

Case 1: DFL =
Case 2: DFL =
28
SECOND METHOD TO CALCULATE DFL

A more direct formula for calculating DFL at a base
level of EBIT is shown below.
DFL at base level EBIT =
EBIT
EBIT I [PD x 1/(1-T)]
DFL at $10,000 EBIT =

DFL at $10,000 EBIT =
29
TOTAL LEVERAGE
30
TOTAL LEVERAGE
The total leverage is the result of both Operating and
Financial leverages
It will tell us the relation between the changes in EPS with
respect a change in sales.
31
Mini-Exercise
Cables Inc., a computer cable manufacturer, expects sales of
20,000 units at $5 per unit in the coming year and must meet
the following obligations: variable operating costs of $2 per
unit, fixed operating costs of $10,000, interest of $20,000, and
preferred stock dividends of $12,000. The firm is in the 40%
tax bracket and has 5,000 shares of common stock
outstanding. Table 12.7 on the following slide summarizes
these figures.
32
DEGREE OF TOTAL LEVERAGE (DTL)

There are three ways to calculate it.
This number will tell me how much my EPS will vary
depending on changes in my Sales
DTL = Percentage change in EPS

DTL at base sales level =

2
3
Q x (P VC)
Q x (P VC) FC I [PD x 1/(1-T)]
DTL = DOL x DFL

33
Mini-Exercise (Cont)
34
FIRST METHOD TO CALCULATE DTL

DTL = Percentage change in EPS
Applying this equation to the data:

Degree of Total Leverage (DTL) =
35
SECOND METHOD TO CALCULATE DTL

A more direct formula for calculating DTL at a base
level of Sales, Q, is shown below.
DTL at base sales level =
Q x (P VC)
Q x (P VC) FC I [PD x 1/(1-T)]
DTL at 20,000 units =

DTL at 20,000 units =
36
THIRD METHOD TO CALCULATE DTL

The relationship between the DTL, DOL, and DFL is illustrated
in the following equation:
DTL = DOL x DFL
Applying this to our previous example we get:
DTL =
37
For the Next Class

Leverage exercises.
38

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TYPES OF LEVERAGE

Elaborated by and for exclusive use of Ignacio

Questions and answers

Why do we need to know about

Generally, increases in leverage result in increases in risk and

More risks, we tend to expect more return (profitability). And

OPERATING AND FINANCIAL LEVERAGE AND THE

Break-even point analysis: I have to find my equilibrium point of sales to

(our operating costs).

This tells us the equilibrium point we must reach.

Variable cost per unit

Fixed Costs = $10.000

Units for eq. = 2.000

Source: Gitman, Principles of Managerial Finance

(2) Operating BE point =

(3) Operating BE point =

(4) Operating BE point =

Source: Gitman, Principles of Managerial Finance

DEGREE OF OPERATING LEVERAGE

There are two ways to calculate it.

This number will tell me how much my profits before

interests (EBIT) will vary depending on sales changes

DOL = Percentage change in EBIT

DOL at base Sales level Q =

LETS RETURN TO THE FIRST EXERCISE

Fixed Costs: $2.500

FIRST METHOD TO CALCULATE DOL

Applying this equation to cases 1 and 2 in Table 12.4

SECOND METHOD TO CALCULATE DOL

DOL at 1,000 units =

The annual interest on the bond issue is $2,000 (10% x

Source: Gitman, Principles of Managerial Finance

DEGREE OF FINANCIAL LEVERAGE (DFL)

will vary depending on changes in my EBIT

DFL = Percentage change in EPS

DFL at base level EBIT =

FIRST METHOD TO CALCULATE DFL

Applying this equation to cases 1 and 2:

SECOND METHOD TO CALCULATE DFL

level of EBIT is shown below.

DFL at base level EBIT =

DFL at $10,000 EBIT =

DEGREE OF TOTAL LEVERAGE (DTL)

depending on changes in my Sales

DTL = Percentage change in EPS

DTL at base sales level =

DTL = DOL x DFL

Source: Gitman, Principles of Managerial Finance

FIRST METHOD TO CALCULATE DTL

Applying this equation to the data:

SECOND METHOD TO CALCULATE DTL

level of Sales, Q, is shown below.

DTL at base sales level =

DTL at 20,000 units =

THIRD METHOD TO CALCULATE DTL

For the Next Class

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