LEVERAGES

Costs
Variable operating costs
Materials Labor Energy Packaging Sales commissions

Fixed operating costs

Administrative salaries Insurance Rent Property tax

Breakeven Analysis
RS

Total Revenue

Total Cost

FC

{
Quantity

Breakeven Analysis
Rs
Total Revenue

EBIT

Total Cost

FC

{
Q1
Quantity

Breakeven Analysis
Total Revenue

Rs

}
+

EBIT
Total Cost

FC

{
Break-even point

Q1

Quantity

Income Statement
Sales/Revenues Variable costs Fixed costs Operating income/EBIT Interest EBT Taxes Net income

Income Statement
Sales/Revenue profit contribution Variable costs Fixed costs Operating income Interest EBT Taxes Net income

Break-even Analysis
Calculation of Break-even Quantity
Q be= Where: Unit Qbe = FC = p = vc =

FC p vc

Break-even quantity Total fixed costs Sales price per unit Variable costs per unit

Break-even Analysis
Calculation of Break-even Quantity
Q be= Example: Fixed Costs = Rs.1,000,000/year Price = Rs.800/unit Variable Costs= 400/unit

FC p vc

Break-even Analysis
Calculation of Break-even Quantity
Q be=

FC p vc

Example: Fixed Costs = Rs.1,000,000/year Price = Rs.800/unit Variable Costs= 400/unit = 1,000,000 800 400 = 2,500 units

Break-even Analysis
Calculate total revenue for different levels of sales. TR = p x Q
Unit sales (Q) 0 500 1,000 2,000 2,500 x Price (p) x 800 x 800 x 800 x 800 x 800 = Total Revenue (TR) = 0 = 400,000 = 800,000 = 1,600,000 = 2,000,000

Assumptions: The Break-even Graph

The slope of the total revenue line is p, the price per unit. The slope of the total cost line is vc, the variable cost per unit.

Graphical Analysis of Break-even Point

Total Costs Total Revenue

Total Costs

2,000,000

Variable Costs

Fixed Costs
1,000,000

Qbe = 2,500 Break-even Quantity

The Concept of Leverage

You cannot easily move a large boulder.

The Concept of Leverage

However, with the aid of a lever you can move an object many times your size.

The Concept of Leverage

The longer the lever, the bigger the rock you can move.

The Concept of Leverage

In a financial context, the magnifying power of leverage can be used to help (or hurt) a firms financial performance.

The employment of an asset or source of funds for which the firms has to pay a fixed cost or fixed return may be termed as leverage.

Types of Leverage
Operating Leverage
Due to fixed operating costs associated with the production of goods or services

Financial Leverage
Due to the existence of fixed financing costs- in particular, interest on debt

Operating Leverage

What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

Total Revenue

Rs.

+
50

EBIT
Total Cost

Break-even point

FC
Quantity

Total Revenue

Rs.

+
100

EBIT
Total Cost = Fixed

FC

Break-even point

Quantity

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
EBIT

Example
Base
Sales Operating costs Fixed Variable Operating profit (EBIT) 200000(2000 units @ Rs. 100 each) 50000 100000 (@ Rs. 50/unit) 50000

Impact of Operating Leverage on Profits

Case 2 -50% 100000
50000 50000 0 -100%

Base
200000 50000 100000 50000

Sales Operating costs Fixed Variable Operating profit (EBIT)

Case 1 +50% 300000

50000 150000 100000 +100%

Degree of Operating Leverage (DOL)

Degree of Operating Leverage -- The percentage change in a firms operating profit (EBIT) resulting from a 1 percent change in output (sales). DOL at Q units of output (or sales) Percentage change in operating profit (EBIT) Percentage change in output (or sales)

Computing the DOL

DOLQ units = EBIT EBIT

Q Q
EBIT = Q(P-V) Q (P - V)

EBIT = Q(P-V) - FC

Q * DOLQ units = Q Q (P - V) - FC

Computing the DOL

Q (P - V) DOLQ units

=
Q (P - V) - FC

Total Contribution

EBIT

Example
Lisa Miller wants to determine the degree of operating leverage at sales levels of 6,000 and 8,000 units. Assuming that:

Fixed costs are $100,000

Baskets are sold for $43.75 each Variable costs are $18.75 per basket

Computing BWs DOL

6,000 * 25 = DOL6,000 units= 6,000 * 25 1,00,000 8,000 * 25 = DOL8,000 units = 8,000 * 25 1,00,000

3 2

Interpretation of the DOL

A 1% increase in sales above the 8,000 unit level increases EBIT by 2% because of the existing operating leverage of the firm. 8,000 = 8,000 - 4,000
2

DOL8,000 units =

Firms with high operating leverage, where DOL > 1 have: rapid increases in profits when sales expand rapid increases in losses when sales fall greater risk

Financial Leverage
Financial Leverage -- The use of fixed financing costs by the firm.
Financial leverage is acquired by choice. Used as a means of increasing the return to common shareholders.

Impact of Financial Leverage on Profits

Base EBIT Less:Interest EBT Less: Tax@35% EAT Less: Pref.Div. EACS EPS(for 1000 CS) 10000 2000 8000 2800 5200 2000 3200 3.2

Impact of Financial Leverage on Profits

Case 2 -40% 6000 2000 4000 1400 2600 2000 600 0.6 -81.25% Base
10000 2000 8000 2800 5200 2000 3200 3.2

EBIT Less:Interest EBT Less: Tax@35% EAT Less: Pref.Div. EACS EPS(for 1000 CS)

Case 1 +40% 14000 2000 12000 4200 7800 2000 5800 5.8 +81.25%

Degree of Financial Leverage (DFL)

Degree of Financial Leverage -- The percentage change in a firms earnings per share (EPS) resulting from a 1 percent change in operating profit.
DFL at EBIT of X dollars Percentage change in earnings per share (EPS) Percentage change in operating profit (EBIT)

Degree of Financial Leverage

DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT

Degree of Financial Leverage

(EBIT-I)(1-t) - Dp EPS = = N [Q(S-V)-F- I](1 - t) - Dp N

EPS = [Q(S-V)](1 - t) N [Q(S-V)](1 - t) EPS = EPS [Q(S-V)-F- I](1 - t) - Dp = Q(S-V) [Q(S-V)-F- I]- Dp/(1 -

Degree of Financial Leverage

DFL =

* [Q(S-V)-F- I]- Dp/(1 t)

Q(S-V)

Q (S - V) - F Q (S - V)

EBIT DFL = EBIT- I - Dp/(1 - t)

OR

EBIT DFL = EBIT - I

EBIT-EPS Analysis
Analysis of the effect of financing alternatives on earnings per share.
Calculate EPS for a given level of EBIT at a given financing structure.

EPS

(EBIT - I) (1 - t) - Pref. Div. No. of Common Shares

EBIT-EPS Chart
Basket Wonders has $2 million in LT financing (100% common stock equity). Current common equity shares = 50,000 $1 million in new financing of either: All C.S. sold at $20/share (50,000 shares) All debt with a coupon rate of 10% All P.S. with a dividend rate of 9% Expected EBIT = $1,50,000; $5,00,000 Income tax rate is 30%

EBIT-EPS Calculation with New Equity Financing

Common Stock Equity Alternative

EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS

$500,000 0 $500,000 150,000 $350,000 0 $350,000 100,000 $3.50

$150,000 0 $150,000 45,000 $105,000 0 $105,000 100,000 $1.05

EBIT-EPS Calculation with New Debt Financing

Long-term Debt Alternative

EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS

$500,000 100,000 $400,000 120,000 $280,000 0 $280,000 50,000 $5.60

$150,000* 100,000 $ 50,000 15,000 $ 35,000 0 $ 35,000 50,000 $0.70

* A second analysis using $150,000 EBIT rather than the expected EBIT.

EBIT-EPS Calculation with New Preferred Financing

Preferred Stock Alternative

EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS

$500,000 0 $500,000 150,000 $350,000 90,000 $260,000 50,000 $5.20

$150,000 0 $150,000 45,000 $105,000 90,000 $ 15,000 50,000 $0.30

* A second analysis using $150,000 EBIT rather than the expected EBIT.

EBIT-EPS Chart
Earnings per Share ($)
6
5 4 3 2 1 0 0 100 200 300 400 500 600 700 Indifference point between debt and common stock financing

Debt

Preferred

Common
Indifference point between preferred stock and common stock financing

EBIT ($ thousands)

What is the DFL for Each of the Financing Choices?

Calculating the DFL for NEW equity* alternative

DFL $500,000

= =

$500,000 $500,000 - 0 - [0 / (1 - 0)] 1.00

* The calculation is based on the expected EBIT

What is the DFL for Each of the Financing Choices?

Calculating the DFL for NEW debt * alternative

DFL $500,000

= =
=

$500,000 { $500,000 - 100,000 - [0 / (1 - 0)] } $500,000 / $400,000 1.25

* The calculation is based on the expected EBIT

What is the DFL for Each of the Financing Choices?

Calculating the DFL for NEW preferred * alternative

DFL $500,000

$500,000 = { $500,000 - 0 - [90,000 / (1 - .30)] }

=
=

$500,000 / $400,000 1.35

* The calculation is based on the expected EBIT

Variability of EPS
DFLEquity = 1.00 Which financing method will have the greatest relative variability in EPS?

DFLDebt

= 1.25

DFLPreferred = 1.35

Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL.

Indifference Point
The indifference point is the EBIT level where EPS is the same for two (or more) alternatives.

Algebraic Approach- Indifference Point

For a new Company: EBIT*(1-t) (EBIT I)*(1-t) - P = N1 N2
For an Existing Company:
(EBIT I1)*(1-t) P1 N1 (EBIT I1 I2)*(1-t) P1-P2 = N2

Financial Break-Even Point

Financial BEP is the level of EBIT which is equal to firms fixed financial costs.
-It is the level of EBIT at which the firm can satisfy all fixed
financial charges. -EBIT less than this level will result in negative EPS

Financial BEP = I + Dp 1- t

What is an Appropriate Amount of Financial Leverage?

Debt Capacity -- The maximum amount of debt (and other fixed-charge financing) that a firm can adequately service. Firms must first analyze their expected future cash flows. The greater and more stable the expected future cash flows, the greater the debt capacity.

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

Degree of Combined Leverage

DCL = DOL x DFL % change in EPS = % change in Sales change in EPS EPS change in Sales Sales

OR
Contribution EBIT DCL = * EBIT EBIT - I =

Contribution EBIT - 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

Usefulness of DCL
Indicates the effect that sales changes will have on EPS Helps in choosing financial plans for new investments