Analysis and Impact

of Leverages

Dr Pawan Gupta
What is Leverage?
 2 more concepts that enhance our
understanding of risk...

1) Operati ng Leverage -
aff ects a fir m’ s
busi ness ri sk.

2) Fi nanci al Lev erage -

aff ects a fir m’ s
financi al ri sk.
 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .
 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .

EBIT
 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .

EBIT FIRM
 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .

EBIT FIRM EPS

 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .
Stock-
EBIT FIRM EPS holders
 Business Risk

• The vari ability or

uncer tainty of a firm’ s
oper ating income
(E BIT) .
Stock-
EBIT FIRM EPS holders
 Business Risk

Affe cted by:

• Sales vo lume
var iability ,
• Compet ition,
• Cos t v ariability ,
• Product
diver sification,
• Product demand
 Operating Leverage

• The use of f ixed

oper ating cost s as
oppose d t o var iable
oper ating cost s.
• A f irm with r elative ly
high fixed operatin g
cost s w ill experience
mor e v ariable
oper ating income if
EBIT

Operating
Leverage
 Financial Risk
• The varia bility or
uncer tainty of a firm’ s
ear ni ngs per s hare
(E PS ) and t he
incr eased probabilit y
of insolv ency that
ar ises w hen a f ir m
us es fi nancia l
lev erage.
 Financial Risk
• The varia bility or
uncer tainty of a firm’ s
ear ni ngs per s hare
(E PS ) and t he
incr eased probabilit y
of insolv ency that
ar ises w hen a f ir m
us es fi nancia l
Stock-
E lev erage.
FIRM EPS holders
BIT
 Financial Risk
• The var iability o r
uncer tainty of a firm’ s
ear nings per share
(E PS) and t he
incr eased probabi li ty
of insolv ency t hat
ar ises when a f ir m
us es financial
lev erage. Stock-
EBIT FIRM EPS holders
 Financial Leverage

• The use of f ixed-cos t

sour ces of f inanci ng
(debt, preferr ed st ock)
ra ther t han varia ble-cos t
sour ces (common st ock) .
EPS

Financial
Leverage
 Breakeven Analysis
$

Quantity
 Total Revenue

Quantity
 Costs

• Suppose the firm h as

both fixed opera ting
cost s (administ rativ e
salar ies, ins urance, re nt,
pr operty tax) and
var iable operat ing cost s
(materia ls, labor,
ener gy, packaging, sales
 Total Revenue

$ Total Cost

FC {
Quantity
 Total Revenue

$ Total Cost
}EBIT
+

-
FC {
Break- Q1 Quantity
even
point
 Operati ng
Leverage

• What h appens if t he f irm

increas es it s fixed
oper ating cost s and
re duces ( or eliminates )
its var iable costs ?
 Total Revenue

+ } EBIT

{
Total Cost
FC - = Fixed

Break- Q1 Quantity
even
point
With high oper ating
lev erage , an
increase in sales
pr oduces a
relativel y larger
incr ease in
oper ating income .
 Total Revenue
Trade-off:
$ the firm has

}
a higher breakeven
EBIT
point. If sales are not
+
high enough, the firm

{
will not meet its fixed
Total Cost
FC - expenses!
= Fixed

Break- Q1 Quantity
even
point
 Breakeven Calculations
Breakeven point ( unit s
of output )
F
QB =
P-V
 Breakeven Calculations
Breakeven point ( unit s
of output )
F
QB =
P-V

• Q B = breakev en level of
Q.
• F = total a nticipated
fixed cost s.
 Breakeven Calculations
Br eakeven point ( sales
dollars ) F
S* = 1-
VC
S
 Breakeven Calculations
Br eakeven point ( sales
dollars ) F
S* = 1-
VC
S

• S* = breakeve n l evel
of sales .
• F = total ant icipated
fixed cost s.
 Analytical Income
Statement
Sales
- var iable costs
- f ix ed costs
oper ating income
- inter est
EBT
- taxes
Net Income
 Analytical Income
Statement
Sales
- }contribution margin
var iable costs
- f ix ed costs
oper ating income
- inter est
EBT
- taxes
Net Income
 Analytical Income
Statement
Sales
- var iable costs
- f ix ed costs
oper ating income
- inter est
EBT (1 - t) = Net Income,
EBT
so,
- taxes Net Income / (1 - t) = EBT
Net Income
 Degree of Operating
Leverage (DOL)
• Oper ating leve rage: by
us ing f ixed oper ating
cost s, a s mall change in
sa les rev enue is magnified
into a la rger change in
oper ating income .
This “multi plier eff ect ” is
called t he degree of
Degree of Operating Leverage
from Sales Level (S)

DOLs = % change in EBIT

% change in sales
Degree of Operating Leverage
from Sales Level (S)

DOLs = % change in EBIT

% change in sales

change in EBIT
EBIT
=
change in sales
sales
 Degree of Operating Leverage
from Sales Level (S)

• If w e have the dat a, we

can use this formula:
Sales - Variable Costs
DOLs =
EBIT
 Degree of Operating Leverage
from Sales Level (S)

• If w e have the dat a, we

can use this formula:
DOLs = Sales - Variable Costs
EBIT

= Q(P - V)
Q(P - V) - F
 What does this tell us?

• If DOL = 2 , then a 1%
increase in sale s will
resul t in a 2%
increase in op erati ng
income (EBI T).
 What does this tell us?

• If DOL = 2 , then a 1%
increase in sale s wi ll
resul t in a 2%
increase in ope rati ng
income (EBI T).
Stock-
Sales EBIT EPS holders
 Degree of Financial
Leverage (DFL)
• Financial leve rage: by
usi ng f ixed cost f inancin g,
a s mall change in
oper ating income is
magnified into a lar ger
change in earn ings per
shar e.
Th is “multiplier ef fect” is
Degree of Financial Leverage

DFL = % change in EPS

% change in EBIT
Degree of Financial Leverage

DFL = % change in EPS

% change in EBIT

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

• If w e have the dat a, we

can use this formula:
DFL = EBIT
EBIT - I
 What does this tell us?

• If DFL = 3, then a 1%
increase in op erati ng
income will r esul t in a
3% increase in
earni ngs per share.
 What does this tell us?

• If DFL = 3, then a 1%
increase in op erati ng
income will r esul t in a
3% increase in
earni ngs per share.
Stock-
Sales EBIT EPS holders
 Degree of Combined
Leverage (DCL)
• Combined lever age: b y using
oper ating lev erage and
financial lever age , a small
change in sales is magnified
int o a larger c hange in
ear nings per share .

• This “mult iplier eff ect ” is

called t he degree of
Degree of Combined Leverage

DCL = DOL x DFL

% change in EPS
=
% change in Sales

change in EPS
EPS
=
change in Sales
Sales
 Degree of Combined Leverage

• If w e have the dat a, we

can use this formula:
DCL = Sales - Variable Costs
EBIT - I
 Degree of Combined Leverage

• If w e have the dat a, we

can use this formula:
DCL = Sales - Variable Costs
EBIT - I

= Q(P - V)
Q(P - V) - F - I
 Leverage

Sales

DCL DOL

EPS EBIT
DFL