Professional Documents
Culture Documents
Operating and
Financial Leverage
16-1
16-2
Operating and
Financial Leverage
Operating Leverage
Financial Leverage
Total Leverage
Combination of Methods
16-3
Operating Leverage
Operating Leverage -- The use of
fixed operating costs by the firm.
16-4
Impact of Operating
Leverage on Profits
(in thousands)
Firm F
$10
Sales
Operating Costs
Fixed
7
Variable
2
Operating Profit $ 1
FC/total costs
FC/sales
16-5
.78
.70
Firm V Firm 2F
$11
$19.5
2
7
$ 2
14
3
$ 2.5
.22
.18
.82
.72
Impact of Operating
Leverage on Profits
16-6
[ ] Firm V;
V
[ ] Firm 2F.
2F
Impact of Operating
Leverage on Profits
(in thousands)
Firm F
$15
Sales
Operating Costs
Fixed
7
Variable
3
Operating Profit $ 5
Percentage
Change in EBIT*
EBIT 400%
16-7
Firm V Firm 2F
$16.5
$29.25
2
10.5
$ 4
100%
14
4.5
$10.75
330%
Impact of Operating
Leverage on Profits
16-8
Break-Even Analysis
Break-Even Analysis -- A technique for
studying the relationship among fixed
costs, variable costs, sales volume,
and profits.
profits Also called
cost/volume/profit (C/V/P) analysis.
16-9
Break-Even Chart
REVENUES AND COSTS
($ thousands)
Total Revenues
Profits
250
Total Costs
175
Fixed Costs
100
Losses
50
0
16-10
Variable Costs
Break-Even
(Quantity) Point
Break-Even Point -- The sales volume required
so that total revenues and total costs are
equal; may be in units or in sales dollars.
Break-Even
(Quantity) Point
Breakeven occurs when EBIT = 0
Q (P - V) - FC
= EBIT
QBE (P - V) - FC = 0
16-12
QBE (P - V)
= FC
QBE
= FC / (P - V)
a.k.a. Unit Contribution Margin
SBE = FC + (VCBE)
SBE = FC + (QBE )(V)
or
SBE *
= FC / [1 - (VC / S) ]
* Refer to text for derivation of the formula
16-13
Break-Even
Point Example
Basket Wonders (BW) wants to
determine both the quantity and sales
break-even points when:
16-14
Break-Even Chart
REVENUES AND COSTS
($ thousands)
Total Revenues
Profits
250
Total Costs
175
Fixed Costs
100
Losses
50
0
16-16
Variable Costs
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)
16-17
Percentage change in
operating profit (EBIT)
Percentage change in
output (or sales)
=
=
16-18
Q (P - V )
Q (P - V) - FC
Q
Q - QBE
16-19
S - VC
S - VC - FC
EBIT + FC
EBIT
Break-Even
Point Example
Lisa Miller wants to determine the degree
of operating leverage at sales levels of
6,000 and 8,000 units.
units As we did earlier,
we will assume that:
16-20
6,000
=
6,000 - 4,000
DOL8,000 units =
8,000
=
8,000 - 4,000
16-21
8,000
=
8,000 - 4,000
DEGREE OF OPERATING
LEVERAGE (DOL)
2,000
4,000
6,000
QBE
QUANTITY PRODUCED AND SOLD
16-23
8,000
16-24
16-25
DOL$10,000 sales
16-26
1,000 + 7,000
=
1,000
8.0
DOL$11,000 sales
16-27
2,000 + 2,000
=
2,000
2.0
DOL$19,500 sales
16-28
2,500 + 14,000
=
=
2,500
6.6
Financial Leverage
Financial Leverage -- The use of
fixed financing costs by the firm.
The British expression is gearing.
16-30
EBIT-EPS Break-Even,
or Indifference, Analysis
EBIT-EPS Break-Even Analysis -- Analysis
of the effect of financing alternatives on
earnings per share. The break-even point is
the EBIT level where EPS is the same for
two (or more) alternatives.
Calculate EPS for a given level of EBIT at a
given financing structure.
EPS
16-31
EBIT-EPS Chart
Basket Wonders has $2 million in LT financing
(100% common stock equity).
16-32
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-34
6
5
Common
4
3
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-36
Debt
6
5
Indifference point
between debt and
common stock
financing
4
3
Common
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
* A second analysis using $150,000 EBIT rather than the expected EBIT.
EBIT-EPS Chart
16-38
Debt
Preferred
Common
4
3
Indifference point
between preferred
stock and common
stock financing
2
1
0
100
200
300
400
500
EBIT ($ thousands)
600
700
6
Lower risk.
risk Only a small
probability that EPS will
be less if the debt
alternative is chosen.
5
4
Common
3
2
1
0
100
200
300
400
500
600
EBIT ($ thousands)
700
Probability of Occurrence
16-39
Debt
(for the probability distribution)
Higher risk.
risk A much larger
probability that EPS will
be less if the debt
alternative is chosen.
5
4
Common
3
2
1
0
100
200
300
400
500
600
EBIT ($ thousands)
700
Probability of Occurrence
16-40
Debt
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.
16-41
Percentage change in
DFL at
earnings per share (EPS)
EBIT of
X dollars = Percentage change in
operating profit (EBIT)
EBIT
EBIT - I - [ PD / (1 - t) ]
DFL $500,000
=
=
16-43
$500,000
$500,000 - 0 - [0 / (1 - 0)]
1.00
DFL $500,000
16-44
$500,000
{ $500,000 - 100,000
- [0 / (1 - 0)] }
$500,000 / $400,000
1.25
DFL $500,000
16-45
$500,000
=
{ $500,000 - 0
- [90,000 / (1 - .30)]
.30 }
=
$500,000 / $400,000
1.35
Variability of EPS
DFLEquity
Which financing
method will have
DFLDebt
= 1.25
the greatest relative
variability in EPS?
DFLPreferred = 1.35
Preferred stock financing will lead to
the greatest variability in earnings per
share based on the DFL.
16-46
= 1.00
Financial Risk
Financial Risk -- The added variability in
earnings per share (EPS) -- plus the risk of
possible insolvency -- that is induced by the
use of financial leverage.
16-47
16-48
Degree of Total
Leverage (DTL)
Degree of Total Leverage -- The
percentage change in a firms earnings
per share (EPS) resulting from a 1
percent change in output (sales).
Percentage change in
DTL at Q units
(or S dollars) earnings per share (EPS)
of output (or = Percentage change in
sales)
output (or sales)
16-49
DTL Q units
16-50
EBIT + FC
EBIT - I - [ PD / (1 - t) ]
Q (P - V )
=
Q (P - V) - FC - I - [ PD / (1 - t) ]
DTL Example
Lisa Miller wants to determine the
Degree of Total Leverage at
EBIT=$500,000. As we did earlier, we
will assume that:
Fixed
16-51
Baskets
Variable
of sales
=
16-52
$500,000 + $100,000
$500,000 - 0 - [ 0 / (1 - .3)
.3 ]
1.20
*Note: No financial leverage.
of sales
=
16-53
$500,000 + $100,000
{ $500,000 - $100,000
- [ 0 / (1 - .3)
.3 ] }
1.50
*Note: Calculated on Slide 16-44.
E(EPS)
$3.50
$5.60
DTL
1.20
1.50
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.
16-55
Coverage Ratios
Income Statement
Ratios
Coverage Ratios
Indicates a firms
ability to cover
interest charges.
16-56
Interest Coverage
EBIT
Interest expenses
A ratio value equal to 1
indicates that earnings
are just sufficient to
cover interest charges.
Coverage Ratios
Income Statement
Ratios
Coverage Ratios
Indicates a firms
ability to cover
interest expenses and
principal payments.
16-57
Debt-service Coverage
EBIT
{ Interest expenses +
[Principal payments / (1-t) ] }
Coverage Example
Make an examination of the coverage
ratios for Basket Wonders when
EBIT=$500,000. Compare the equity
and the debt financing alternatives.
Assume that:
that
Interest
Principal
16-58
Coverage Example
Compare the interest coverage and debt
burden ratios for equity and debt financing.
Financing
Equity
Debt
Interest
Coverage
Infinite
5.00
Debt-service
Coverage
Infinite
2.50
PROBABILITY OF OCCURRENCE
Coverage Example
Firm B has a much
smaller probability
of failing to meet its
obligations than Firm A.
Firm A
Debt-service burden
= $200,000
-250
16-60
Firm B
250
500
750
EBIT ($ thousands)
1,000
1,250
16-61
16-62
16-63
Investment bankers
Institutional investors
Investment analysts
Lenders
16-64