Operating Leverage - Finacial leverage & Break-Even
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The document discusses the concepts of operating and financial leverage, emphasizing their impact on business and financial risk, respectively. It details how operating leverage, by utilizing fixed costs, can amplify changes in operating income from sales fluctuations, while financial leverage relates to how debt increases earnings per share volatility. Key calculations for break-even points and degrees of leverage are presented, highlighting their significance in evaluating a firm's performance and risk management.
Operating Leverage - Finacial leverage & Break-Even
- 1. Break-Even and Leverage ļ®Operating Leverage ļ®Financial Leverage
- 5. 2 more concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firmās business risk. 2) Financial Leverage - affects a firmās financial risk.
- 6. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT).
- 7. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT). EBIT
- 8. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT). EBIT FIRM
- 9. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT). EBIT FIRM EPS
- 10. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT). EBIT FIRM EPS Stock-holders
- 11. Business Risk ļ® The variability or uncertainty of a firmās operating income (EBIT). EBIT FIRM EPS Stock-holders
- 12. Business Risk Affected by: ļ® Sales volume variability, ļ® Competition, ļ® Cost variability, ļ® Product diversification, ļ® Product demand ļ® Operating Leverage.
- 13. Operating Leverage ļ® The use of fixed operating costs as opposed to variable operating costs. ļ® A firm with relatively high fixed operating costs will experience more variable operating income if sales change.
- 15. Financial Risk ļ® The variability or uncertainty of a firmās earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.
- 16. Financial Risk ļ® The variability or uncertainty of a firmās earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT FIRM EPS Stock-holders
- 17. Financial Risk ļ® The variability or uncertainty of a firmās earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. EBIT FIRM EPS Stock-holders
- 18. Financial Leverage ļ® The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).
- 20. Quantity $ Breakeven Analysis
- 21. Quantity $ Total Revenue
- 22. Costs ļ® Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).
- 23. Quantity { $ Total Revenue Total Cost FC
- 24. Quantity { $ Total Revenue Total Cost FC Break-even point }EBIT Q1 + -
- 25. Operating Leverage ļ® What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?
- 26. Quantity $ { Total Revenue Total Cost FC = Fixed Break-even point } Q1 + - EBIT
- 27. With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
- 28. Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed Quantity $ { Total Revenue Total Cost FC = Fixed Break-even point } Q1 + - EBIT expenses!
- 29. Breakeven Calculations Breakeven point (units of output) QB = FC p ā v
- 30. Breakeven Calculations Breakeven point (units of output) QB = FC p - v ļ®QB = breakeven level of Q. ļ® F = total anticipated fixed costs. ļ® P = sales price per unit. ļ® V = variable cost per unit.
- 31. Breakeven Calculations Breakeven point (sales dollars) S* = F VC S 1 -
- 32. Breakeven Calculations Breakeven point (sales dollars) S* = F VC S 1 - ļ® S* = breakeven level of sales. ļ® F = total anticipated fixed costs. ļ® S = total sales. ļ® VC = total variable costs.
- 33. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income
- 34. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income } contribution margin
- 35. Analytical Income Statement Sales - variable costs - fixed costs operating income - interest EBT - taxes Net Income EBT (1 - t) = Net Income, so, Net Income / (1 - t) = EBT
- 36. Degree of Operating Leverage (DOL) ļ® Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income. ļ® This āmultiplier effectā is called the degree of operating leverage.
- 37. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales
- 38. Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales =
- 39. Degree of Operating Leverage ļ® If we have the data, we can use this formula: DOLs = from Sales Level (S) Sales - Variable Costs EBIT
- 40. Degree of Operating Leverage DOLs = from Sales Level (S) ļ® If we have the data, we can use this formula: Sales - Variable Costs EBIT Q(p - v) Q(p - v) - FC =
- 41. What does this tell us? ļ® If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).
- 42. What does this tell us? ļ® If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- EBIT holders Sales EPS
- 43. Degree of Financial Leverage (DFL) ļ® Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share. ļ® This āmultiplier effectā is called the degree of financial leverage.
- 44. Degree of Financial Leverage DFL = % change in EPS % change in EBIT
- 45. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =
- 46. Degree of Financial Leverage ļ® If we have the data, we can use this formula: DFL = EBIT EBIT - I
- 47. DFL in case where there is preferred stock PD T EBIT EBIT I DFL ļ ļ ļ ļ½ 1
- 48. What does this tell us? ļ® If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.
- 49. What does this tell us? ļ® If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- EBIT holders Sales EPS
- 50. Degree of Combined Leverage (DCL) ļ® Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share. ļ® This āmultiplier effectā is called the degree of combined leverage.
- 51. Degree of Combined Leverage DCL = DOL x DFL % change in EPS % change in Sales = change in EPS EPS change in Sales Sales =
- 52. Degree of Combined Leverage ļ® If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - I
- 53. Degree of Combined Leverage ļ® If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - I Q(p - v) Q(p - v) - FC - I =
- 54. DCL where there is preferred stock Sales VariableCost PD T EBIT I DFL ļ ļ ļ ļ ļ½ 1
- 55. What does this tell us? ļ® If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.
- 56. What does this tell us? ļ® If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- EBIT holders Sales EPS
- 57. Team Project: ļ® 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?
- 58. 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
- 59. Leverage Sales DOL EPS EBIT DFL DCL
- 60. Levered Company Sales DOL = EPS EBIT DFL DCL
- 61. Levered Company Sales DOL = 1.714 EPS EBIT DFL = DCL
- 62. Levered Company Sales DOL = 1.714 EPS EBIT DFL = 1.556 DCL
- 63. Levered Company Sales DOL = 1.714 DCL = 2.667 EPS EBIT DFL = 1.556
- 64. Levered Company 10% 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%)
- 65. The effect of financial leverage ļ® The more debt financing a firm uses in its capital structure, the more financial leverage it employs. Illustration: ļ® CFO is considering a restructuring that would involve issuing debt and using the proceeds to buy back some of the outstanding equity. ļ® Firmās market value = $ 8,000,000 ļ® Shares outstanding = 400,000 ļ® When all equity firm, price per share = $ 20 ļ® Proposed debt issue would raise $ 4,000,000, interest rate = 10 % ļ® New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares, leaving 2,00,000 ļ® New Debt equity ratio = 1 ļ® Assume that stock price will remain $20 ļ® What is the impact of the proposed restructuring ?
- 66. Illustration (contdā¦) Current Capital Structure: No debt Recession Expected Expansion EBIT $ 5,00,000 $ 1,000,000 $ 1,500,000 Interest 0 0 0 Net Income $ 5,00,000 $ 1,000,000 $ 1,500,000 ROE 6.25 % 12.50 % 18.75 % EPS $ 1.25 $ 2.50 $ 3.75 Proposed Capital Structure: Debt = $ 4,000,000 EBIT $ 500,000 $ 1,000,000 $ 1,500,000 Interest 400,000 400,000 400,000 Net Income $ 100,000 $ 600,000 $ 1,100,000 ROE 2.50 % 15.00 % 27.50 % EPS $ 0.50 $ 3.00 $ 5.50
- 67. Illustration (contdā¦) ā¢ In no debt case, every $ 400,000 increase in EBIT increases EPS by $ 1 ā¢ In proposed capital structure, every $ 400,000 increase in EBIT increases EPS by $ 2 ā¢Breakeven point is indifference point. ā¢If EBIT is above this level, leverage is beneficial, otherwise not.