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9 Chapter 5 - Outline
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What is Leverage? Operating Leverage Financial Leverage Leverage Means Risk Combined or Total Leverage
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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What is Leverage?
Leverage is using fixed costs to magnify the potential return to a firm
2 types of fixed costs: fixed operating costs = rent, depreciation fixed financial costs = interest costs from debt
The McGraw-Hill Companies, Inc. 2000
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Operating Leverage
Measure of the amount of fixed operating costs used by a firm Degree of Operating Leverage (DOL) = %age in EBIT (or OI) / %age in Sales a in Sales a larger in EBIT (or OI) Operating Leverage measures the sensitivity of a firms operating income to a in sales
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Revenue
20
Block Hirt Irwin/McGraw-Hill
40 50 60
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120
The McGraw-Hill Companies, Inc. 2000
Units produced and sold (thousands) Fixed costs ($60,000) Price ($2) Variable costs per unit ($0.80)
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pointPage 115
BE
Fixed costs Fixed costs FC 5 - 1 Contributi on margin Price - Variable cost per unit P - VC
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T 5-2
Fixed Costs
$ 60,000 60,000 60,000 60,000 60,000 60,000 60,000
Total Costs
$ 60,000 76,000 92,000 100,000 108,000 124,000 140,000
Total Revenue
0 $ 40,000 80,000 100,000 120,000 160,000 200,000
0 0 20,000 $16,000 40,000 32,000 50,000 40,000 60,000 48,000 80,000 64,000 100,000 80,000
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T 5-3
Total Revenue
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40
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Units produced and sold (thousands) Block Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60) Hirt Irwin/McGraw-Hill The McGraw-Hill Companies, Inc. 2000
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Total Costs
Operating Total Income Revenue (loss) 0 $ 40,000 60,000 80,000 120,000 160,000 200,000
$ (12,000) (4,000) 0 4,000 12,000 20,000 28,000
. .
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T 5-5
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Cost overruns
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40
Total costs
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60 80 Units (thousands)
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Financial Leverage
Block Hirt Irwin/McGraw-Hill
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Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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Degree of Financial Leverage (DFL) = %age in EPS / %age in EBIT (or OI)
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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9
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(leveraged) 1. EBIT (0) Earnings before interest and taxes (EBIT) 0 Interest (I) $(12,000) Earnings before taxes (EBT) (12,000) Taxes (T) * (6,000) Earnings after taxes (EAT) $ (6,000) Shares 8,000 Earnings per share (EPS) $ (0.75) 2. EBIT ($12,000) Earnings before interest and taxes (EBIT) $12,000 Interest (I) 12,000 Earnings before taxes (EBT) 0 Taxes (T) 0 Earnings after taxes (EAT) $ 0 Shares 8,000 Earnings per share (EPS) 0
. . . .
T 5-7
(conservative) 0
* The assumption is that large losses can be written off against other income, perhaps in other years, thus Block providing the firm with a tax savings benefit. The tax rate is 50 percent for ease of computation. Hirt Irwin/McGraw-Hill The McGraw-Hill Companies, Inc. 2000
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T 5-7
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T 5-8 th EDITION Figure 5-4 Financing plans and earnings per sharePage 121 EPS ($)
4 Plan A 3 2 Plan B
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.25 0 -1 -2
Block Hirt Irwin/McGraw-Hill
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50 75 EBIT (thousands)
100
The McGraw-Hill Companies, Inc. 2000
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In the previous figure (5-4), the point where Plans A and B cross is a financial break-even point.
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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9 If EBIT is to be
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below this BE point, we would prefer Plan B, with a conservative, low level of debt.
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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If EBIT is to be above this BE point, we would prefer Plan A, with an aggressive, high level of debt.
The McGraw-Hill Companies, Inc. 2000
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One way to measure the relative level of debt is to compute the Degree of Financial Leverage (Equations 5-4 and 5-5).
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000
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If a firm has inherent business risk, then it should use debt and fixed costs sparingly to reduce overall risk.
The McGraw-Hill Companies, Inc. 2000
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T 5-9
Financial leverage
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T 5-10 th EDITION Figure 5-5 Combining operating and financial leverage Page 125
$ Earnings generated
EPS = $1.50
Financial leverage
Leverage impact
The McGraw-Hill Companies, Inc. 2000
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T 5-11
Table 5-7 --Operating and financial leverage Page 126 (80,000 units) (100,000 units)
Sales $2 per unit Fixed costs Variable costs ($0.80 per unit) Operating income (EBIT) Interest Earnings before taxes Taxes Earnings after taxes Shares Earnings per share $160,000 60,000 64,000 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50 $200,000 60,000 80,000 60,000 12,000 48,000 24,000 $ 24,000 8,000 $3.00
Note than unit sales increased by 25%; EBIT increased by 67% (operating leverage); and EPS increased by 100% (financial leverage).
The McGraw-Hill Companies, Inc. 2000
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THE END
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000