Operating Leverage

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Chapter 15 Analysis and Impact of Leverage

• Operating Leverage
• Financial Leverage

Ó 2005, Pearson Prentice Hall
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What is Leverage?
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What is Leverage?
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What is Leverage?
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Two concepts that enhance our understanding of
risk...

• 1) Operating Leverage - affects a firms business
  risk.
• 2) Financial Leverage - affects a firms
  financial risk.

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• Affected by
• Sales volume variability
• Competition
• Product diversification
• Operating leverage
• Growth prospects
• Size

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Operating Leverage

• The use of fixed operating costs as opposed to
  variable operating costs.
• A firm with relatively high fixed operating costs
  will experience more variable operating income if
  sales change.

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EBIT
Operating Leverage
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Financial Risk

• The variability or uncertainty of a firms
  earnings per share (EPS) and the increased
  probability of insolvency that arises when a firm
  uses financial leverage.

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Financial Risk

• The variability or uncertainty of a firms
  earnings per share (EPS) and the increased
  probability of insolvency that arises when a firm
  uses financial leverage.

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Financial Risk

• The variability or uncertainty of a firms
  earnings per share (EPS) and the increased
  probability of insolvency that arises when a firm
  uses financial leverage.

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Financial Leverage

• The use of fixed-cost sources of financing (debt,
  preferred stock) rather than variable-cost
  sources (common stock).

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EPS
Financial Leverage
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Breakeven Analysis

• Illustrates the effects of operating leverage.
• Useful for forecasting the profitability of a
  firm, division, or product line.
• Useful for analyzing the impact of changes in
  fixed costs, variable costs, and sales price.

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Breakeven Analysis
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Total Revenue

Quantity
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Costs

• Suppose the firm has both fixed operating costs
  (administrative salaries, insurance, rent,
  property tax) and variable operating costs
  (materials, labor, energy, packaging, sales
  commissions).

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Total Revenue

Quantity
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Total Revenue
Total Cost


FC
Quantity
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Total Revenue
Total Cost


EBIT

-

FC
Quantity
Q1
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Total Revenue
Total Cost


-

FC
Quantity
Q1
Break-even point
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Operating Leverage

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

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Total Revenue
Total Cost


-

FC
Quantity
Break- even point
Q1
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Total Revenue


EBIT


Total Cost Fixed
-
FC
Quantity
Q1
Break-even point
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• With high operating leverage, an increase in
  sales produces a relatively larger increase in
  operating income.

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Trade-off the firm has a higher breakeven
point. If sales are not high enough, the firm
will not meet its fixed expenses!
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Breakeven Calculations
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Breakeven Calculations

• Breakeven point (units of output)

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Breakeven Calculations

• Breakeven point (units of output)
• QB breakeven level of Q.
• F total anticipated fixed costs.
• P sales price per unit.
• V variable cost per unit.

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Breakeven Calculations

• Breakeven point (sales dollars)

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Breakeven Calculations

• Breakeven point (sales dollars)
• S breakeven level of sales.
• F total anticipated fixed costs.
• S total sales.
• VC total variable costs.

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Analytical Income Statement

• sales
• - variable costs
• - fixed costs
• operating income
• - interest
• EBT
• - taxes
• net income

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Degree of Operating Leverage (DOL)

• Operating leverage by using fixed operating
  costs, a small change in sales revenue is
  magnified into a larger change in operating
  income.
• This multiplier effect is called the degree of
  operating leverage.

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Degree of Operating Leveragefrom Sales Level (S)
change in EBIT change in sales
DOLs
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Degree of Operating Leveragefrom Sales Level (S)
change in EBIT change in sales
DOLs
change in EBIT EBIT change in sales
sales

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Degree of Operating Leveragefrom Sales Level (S)

• If we have the data, we can use this formula

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Degree of Operating Leveragefrom Sales Level (S)

• If we have the data, we can use this formula

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Degree of Operating Leveragefrom Sales Level (S)

• If we have the data, we can use this formula

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What does this tell us?

• If DOL 2, then a 1 increase in sales will
  result in a 2 increase in operating income
  (EBIT).

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What does this tell us?

• If DOL 2, then a 1 increase in sales will
  result in a 2 increase in operating income
  (EBIT).

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What does this tell us?

• If DOL 2, then a 1 increase in sales will
  result in a 2 increase in operating income
  (EBIT).

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Degree of Financial Leverage (DFL)

• Financial leverage by using fixed cost
  financing, a small change in operating income is
  magnified into a larger change in earnings per
  share.
• This multiplier effect is called the degree of
  financial leverage.

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Degree of Financial Leverage
change in EPS change in EBIT
DFL
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Degree of Financial Leverage
change in EPS change in EBIT
DFL
change in EPS EPS change in EBIT
EBIT

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Degree of Financial Leverage

• If we have the data, we can use this formula

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Degree of Financial Leverage

• If we have the data, we can use this formula

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What does this tell us?

• If DFL 3, then a 1 increase in operating
  income will result in a 3 increase in earnings
  per share.

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What does this tell us?

• If DFL 3, then a 1 increase in operating
  income will result in a 3 increase in earnings
  per share.

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What does this tell us?

• If DFL 3, then a 1 increase in operating
  income will result in a 3 increase in earnings
  per share.

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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.

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Degree of Combined Leverage
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Degree of Combined Leverage
DCL DOL x DFL
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Degree of Combined Leverage
DCL DOL x DFL
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Degree of Combined Leverage
DCL DOL x DFL
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Degree of Combined Leverage

• If we have the data, we can use this formula

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Degree of Combined Leverage

• If we have the data, we can use this formula

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Degree of Combined Leverage

• If we have the data, we can use this formula

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What does this tell us?

• If DCL 4, then a 1 increase in sales will
  result in a 4 increase in earnings per share.

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What does this tell us?

• If DCL 4, then a 1 increase in sales will
  result in a 4 increase in earnings per share.

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What does this tell us?

• If DCL 4, then a 1 increase in sales will
  result in a 4 increase in earnings per share.

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In-class Project

• Based on the following information on Levered
  Company, answer these questions
• 1) If sales increase by 10, what should happen
  to operating income?
• 2) If operating income increases by 10, what
  should happen to EPS?
• 3) If sales increase by 10, what should be the
  effect on EPS?

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Levered Company

• Sales (100,000 units) 1,400,000
• Variable Costs 800,000
• Fixed Costs 250,000
• Interest paid 125,000
• Tax rate 34
• Common shares outstanding 100,000

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Levered Company
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Degree of Operating Leverage from Sales Level (S)
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Degree of Operating Leverage from Sales Level (S)
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Degree of Operating Leverage from Sales Level (S)
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Degree of Financial Leverage
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Degree of Financial Leverage
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Degree of Financial Leverage
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Degree of Combined Leverage
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Degree of Combined Leverage
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Degree of Combined Leverage
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Levered Company
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Levered Company10 increase in sales

• Sales (110,000 units) 1,540,000
• Variable Costs (880,000)
• Fixed Costs (250,000)
• EBIT 410,000 ( 17.14)
• Interest (125,000)
• EBT 285,000
• Taxes (34) (96,900)
• Net Income 188,100
• EPS 1.881 ( 26.67)