Topic 3

Financial and Operating Leveraging

Business vs. financial risk Operating leverage Financial Leverage Degree of Financial & Operating Leverage
13-1

What is business risk?

Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk

High risk

E(EBIT)

EBIT

Note that business risk does not include financing effects.

13-2

What determines business risk?

Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage.

13-3

What is operating leverage, and how does it affect a firms business risk?

Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged.

13-4

Effect of operating leverage

More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. Rev. Rev. $ $ TC Profit TC FC FC

QBE

Sales

QBE

Sales

For example, convenience stores are significantly less leveraged than high-end car dealerships 13-5

Using operating leverage

Low operating leverage Probability High operating leverage

EBITL

EBITH

Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
13-6

What is financial leverage? Financial risk?

Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

13-7

Business risk vs. Financial risk

Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued.

More debt, more financial risk. Concentrates business risk on stockholders.

13-8

An example: Illustrating effects of financial leverage

Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure).
Firm U No debt $20,000 in assets 40% tax rate Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate
13-9

Firm U: Unleveraged
Prob. EBIT Interest EBT Taxes (40%) NI

Economy Bad Avg. 0.25 0.50 $2,000 $3,000 0 0 $2,000 $3,000 800 1,200 $1,200 $1,800

Good 0.25 $4,000 0 $4,000 1,600 $2,400

13-10

Firm L: Leveraged
Prob.* EBIT* Interest EBT Taxes (40%) NI
*Same as for Firm U.
13-11

Economy Bad Avg. 0.25 0.50 $2,000 $3,000 1,200 1,200 $ 800 $1,800 320 720 $ 480 $1,080

Good 0.25 $4,000 1,200 $2,800 1,120 $1,680

Ratio comparison between leveraged and unleveraged firms

FIRM U
BEP* ROE TIE 10.0% 6.0%

Bad

15.0% 9.0%

Avg

20.0% 12.0%

Good

FIRM L
BEP* ROE TIE

10.0% 4.8% 1.67x

Bad

15.0% 10.8% 2.50x

Avg

20.0% 16.8% 3.30x

Good

*BEP (Basic earning power)

13-12

Risk and return for leveraged and unleveraged firms

Expected Values: E(BEP) E(ROE) E(TIE) Risk Measures: ROE

Firm U 15.0% 9.0%

Firm L 15.0% 10.8% 2.5x

Firm L 4.24%
13-13

Firm U 2.12%

The effect of leverage on profitability and debt coverage

For leverage to raise expected ROE, must have BEP > kd. Why? If kd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = kdD).
13-14

Conclusions

Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > kd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

13-15

Breakeven Analysis
Breakeven Analysis is used to: determine the level of operations necessary to cover all operating costs, and evaluate the profitability associated with various

levels of sales.
The firms operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses.

13-16

Breakeven Analysis
To calculate the OBP, cost of goods sold and operating expenses must be categorized as fixed or variable. Variable costs vary directly with the level of sales and are a function of volume, not time.

Fixed costs are a function of time and do not vary with

sales volume.

13-17

Breakeven Analysis
Algebraic Approach
P Q FC VC = = = = sales price per unit sales quantity in units fixed operating costs per period variable operating costs per unit

EBIT = (P x Q) - FC - (VC x Q) Letting EBIT = 0 and solving for Q, we get:

13-18

Breakeven Analysis
Algebraic/Equation Approach
Using the following variables, the operating portion of a firms income statement may be recast as follows: P Q FC VC = = = = sales price per unit sales quantity in units fixed operating costs per period variable operating costs per unit Q = FC P - VC
13-19

Breakeven Analysis
Algebraic Approach

13-20

Breakeven Analysis
Algebraic Approach
Example: Omnibus Posters has fixed operating costs of $2,500, a sales price of $10/poster, and variable costs of $5/poster. Find the OBP. Q = $2,500 = 500 posters $10 - $5

500 X $10

= $5000

13-21

Algebraic Approach
We can check to verify that this is the case by substituting as follows: EBIT = (P x Q) - FC - (VC x Q) EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 = $0

13-22

Breakeven Analysis
Contribution Margin Approach
The contribution margin method is a variation of the equation method.
Break-even point in units sold Q Break-even point in total sales dollars Fixed expenses = Unit contribution margin = $2,500 = 500 posters $10 - $5 = Fixed expenses CM ratio Fixed expenses (Sales-VC)/Sales

=
$

= $2,500 = $5000 0.5

13-23

Breakeven Analysis
Graphic Approach
EBIT at Various Levels of Quantity Sold
Quantity Sold 500 1,000 1,500 2,000 2,500 3,000 Total Revenue 5,000 10,000 15,000 20,000 25,000 30,000 Total Costs 2,500 7,500 12,500 17,500 22,500 27,500 15,000 Total FC 2,500 2,500 2,500 2,500 2,500 2,500 2,500 Total VC 2,500 5,000 7,500 10,000 12,500 15,000 EBIT (2,500) 2,500 5,000 7,500 10,000 12,500
13-24

Breakeven Analysis
Total Revenue 14,000 12,000
revenue/costs ($)

Total Costs

Total FC

10,000 8,000 6,000 4,000 2,000 500 1,000 sales (posters) 1,500 2,000
13-25

Target Profit Analysis

We can use our Cost Volume profit (CVP) formula to determine the sales volume needed to achieve a target net profit figure.

13-26

Target Profit Analysis

CVP Equation Method

LET SAY YOUR TARGET PROFIT IS $500

Q =

$2,500 + $500 $10 - $5

= 600 posters

600 X $10

= $6000
13-27

Target Profit Analysis

Contribution Margin Approach
The contribution margin method is a variation of the equation method.
Unit sales to attain the target profit Q Fixed expenses = Unit contribution margin = $2,500 + 500 = 600 posters $10 - $5 Fixed expenses CM ratio Fixed expenses (Sales-VC)/Sales

total sales dollars to = Attain the target profit

=
$

= $2,500 + 500 = $6000 0.5

13-28

Margin of Safety (MOS)

Margin of safety (MOS) is the excess of budgeted or actual sales over the breakeven volume of sales. It state the amount by which sales can drop before losses begin to be incurred. The higher the margin of safety, the lower the risk of not breaking even.
13-29

Margin of Safety (MOS)

MOS = Total Actual Sales BE sales Let say; BE = $5000, Sales = $5500 Therefore MOS = 5500 5000 = 500 If in %, MOS(%) = 500/5000 = 0.1 or 10% Therefore if reduction in sales of $500 or 10%, the result will be just break even.
13-30

Operating & Financial Leverage

13-31

Operating & Financial Leverage

Effects of Leverage on the Income Statement
Scenario 1 10% Sales Decrease Net Sales Less: Variable Costs (60% of Sales) Less: Fixed Costs EBIT Less: Interest Expense EBT Less: Taxes (30%) Net Incom e $ 378,000 200,000 52,000 20,000 32,000 9,600 22,400 $ 420,000 200,000 80,000 20,000 60,000 18,000 42,000 $ 462,000 200,000 108,000 20,000 88,000 26,400 61,600 13-32 $ 630,000 $ Scenario 2 Sales Rem ain Unchanged 700,000 $ Scenario 3 10% Sales Increase 770,000

Operating & Financial Leverage

Degree of Operating Leverage
The degree of operating leverage (DOL) measures the
sensitivity of changes in EBIT to changes in Sales.

A companys DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL.
13-33

Operating & Financial Leverage

Degree of Operating Leverage
Effects of Operating Leverage on the Income Statement
Scenario 1 10.0% Net Sales Less: Variable Costs (60% of Sales) Less: Fixed Costs EBIT (52-80)/80 378,000 200,000 52,000 Ebit Decreases 35.0% (108-80)/80 420,000 200,000 80,000 462,000 200,000 108,000 Ebit Increases 35.0% 13-34 $ 630,000 Scenario 2 Unchanged $ 700,000 $ Scenario 3 Sales Increase 10.0% 770,000

Sales Decrease Sales Rem ain

Operating & Financial Leverage

Degree of Operating Leverage
Interval Estimate of DOL
DOL = % Change in EBIT = % Change in Sales 35% 10% = 3.50 x

13-35

Operating & Financial Leverage

Degree of Operating Leverage
Point Estimate of DOL
DOL = CM EBIT

DOL =

Sales - VC = Sales - VC - FC

700 - 420 = 3.50 x 700 - 420 - 200

13-36

Operating & Financial Leverage

Degree of Financial Leverage
The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. Only companies that use debt or other forms of fixed

cost financing (debt or PS) will experience financial

leverage.
13-37

Operating & Financial Leverage

Degree of Financial Leverage
Effects of Financial Leverage on the Income Statement
Scenario 1 EBIT Dcrease 35.00% EBIT Less: Interest Expense EBT Less: Taxes (30%) Net Incom e EPS (42,000 shares) $ $ 52,000 20,000 32,000 9,600 22,400 0.533 46.67% $ $ Scenario 2 Sales Rem ain Unchanged 80,000 20,000 60,000 18,000 42,000 1.00 $ $ Scenario 3 EBIT Increase 35.00% 108,000 20,000 88,000 26,400 61,600 1.467 46.67% 13-38

EPS Decreases

EPS Increases

Operating & Financial Leverage

Degree of Financial Leverage
Interval Estimate of DFL
DFL = % Change in EPS = 46.67% = 1.33 % Change in EBIT 35.00%

13-39

Operating & Financial Leverage

Degree of Financial Leverage
Point Estimate of DFL
DFL = EBIT = EBIT - Interest 80 = 1.33 80 - 20

DFL =

EBIT = EBIT - Interest

108 = 1.23 108 - 20

13-40

Operating & Financial Leverage

Degree of Total Leverage
Effects of Combined Leverage on the Income Statement
Scenario 1 10% Sales Decrease Net Sales Less: Variable Costs (60% of Sales) Less: Fixed Costs EBIT Less: Interest Expense EBT Less: Taxes (30%) Net Incom e EPS (42,000 shares) $ $ 378,000 200,000 52,000 20,000 32,000 9,600 22,400 0.53 46.67% $ $ 420,000 200,000 80,000 20,000 60,000 18,000 42,000 1.00 $ $ 462,000 200,000 108,000 20,000 88,000 26,400 61,600 1.47 46.67% $ 630,000 $ Scenario 2 Sales Rem ain Unchanged 700,000 $ Scenario 3 10% Sales Increase 770,000

EPS Decreases

EPS Increases

13-41

Operating & Financial Leverage

Degree of Total Leverage
Interval Estimate of DTL
DTL = % Change in EPS = % Change in Sales 46.7% 10% = 4.67

13-42

Operating & Financial Leverage

Degree of Total Leverage
Point Estimate of DTL
DTL = Q x (P - VC) Q x (P-VC) - FC - I

DTL =

700 - 420 700 - 420 - 200 - 20

4.67

13-43

Operating & Financial Leverage

Degree of Total Leverage
DTL = DOL x DFL

Applying this to our example at a sales level of $77, we get:

DTL = 3.50 x 1.33 = 4.6

13-44