OPERATING AND FINANCIAL LEVERAGES

By Kartikeya kasera 112 Deepak mehta 114 Gaurav kakkad 207 Aditi mehta 208 Chittesh khilnani 310 Nachiket kulkarni 311

LEVERAGE: THE BASIC PRINCIPLE

Operating cost breakup

Fixed cost

TOTAL OPERATING COST

Variable cost

OPERATING PROFIT(EBIT)

SALES

VARIABLE COST

FIXED COST

OPERATING PROFIT

i.e, S VC FC =EBIT

BREAK EVEN ANALYSIS

BREAK EVEN POINT (BE)- NO profit NO loss.

Condition for Sales Break-Even Point

A general break-even point for a multiproduct firm cant be done using BQP. Assuming that sales of each product are a constant proportion of the firms total sales

BREAK EVEN ANALYSIS (CONTD.)

QBE=FC/(P-V) SBE=FC/[1-(VC/S)] P= price per unit V= variable cost FC= Fixed cost QBE=break even quantity SBE=break even sale c

EXAMPLE
Consider a firm that produces high quality childs bicycle helmet that sells for Rs.50 a unit. The company has annual fixed operating cost of Rs. 100,000 and a variable cost of Rs. 25 per unit.

Break even quantity point: QBE = FC/(P-V) QBE = 100,000/(50-25) QBE =4000 i.e. sales of Rs 200,000

Break even sales point: SBE = FC/ [1-(VC/S)] SBE = 100,000/(1-.5) SBE = 200,000 i.e. 4000 units

OPERATING LEVERAGE

Operating Leverage
It is the firms ability to use fixed operating costs to magnify the effect of changes in sales and its earning before interest and taxes(EBIT). Fixed operating cost-do not change as volumes change Variable operating cost-vary directly with level of output.

FC V/S VC
Fixed cost Depreciation of land and building insurance Utility bills partly Cost of management Variable cost Raw material Direct labor Utility bill partly Direct selling commissions General administration expenses

E X A M P L E

Firm F

Firm V

Firm 2F

Sales
Operating Costs Fixed Variable Operating Profit (EBIT) Operating Leverage ratios FC/Total Costs FC/Sales

$10,000

$11,000

$19,500

7,000 2,000 $1,000

2,000 7,000 $2,000

14,000 3,000 $2,500

0.78 0.70

0.22 0.18

0.82 0.72

Three firms after 50% increases in sales in following years

Firm F Sales Operating Costs Fixed Variable Operating Profit (EBIT) % Change in EBIT 7,000 3,000 $5,000 400% 2,000 10,500 $4,000 100% 14,000 4,500 $10,750 330% $15,000 Firm V $16,500 Firm 2F $29,500

DOL-Degree of operating leverage

Degree of Operating Leverage (DOL)

The percentage change in a firms operating profit (EBIT) resulting from a 1 percent change in output (sales). DOL Q units = % change in EBIT

% change in sales
Q/Q

= EBIT/EBIT

Calculations (contd.)
EBIT= Q(S-V)-F EBIT= Q(S-V) DOL Q units= Q(S-V) x Q
Q(S-V)-F

DOL Q units= Q(S-V) Q(S-V)-F = Q = Q Q-F/(S-V) Q - QBE

To summarize DOL
DOL for a single-product firm.
P = Price per unit FC = Fixed costs

Q units

V = Variable costs per unit Q = Quantity (units) produced and sold

DOLQ units

Q (P - V)
= Q (P - V) - FC = Q Q - QBE

Computing the DOL for multiproduct firm.

DOL for a multi-product firm.
R - VC R - VC - FC EBIT + FC EBIT

DOLsales (R rupees)

DOL and Break-Even Point

QUANTITY PRODUCED AND SOLD (Q) 0 1,000 2,000 3,000 5,000 6,000 7,000 8,000 OPERATING PROFIT (EBIT) ` -1,00,000 -75,000 -50,000 -25,000 0 25,000 50,000 75,000 1,00,000 DEGREE OF OPERATING LEVERAGE (DOL) 0.00 -0.33 -1.00 -3.00 Infinite 5.00 3.00 2.33 2.00

DOL and Break-Even Point

The firms relative proximity to BE point determines its DOL.

Interpretation of DOL
DOL is a quantitative measure of the sensitivity of a firms operating profit to a change in the firms sales. The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL. When comparing firms, the firm with the highest DOL is the firm that will be most sensitive to a change in sales. i.e. it shows the change in EBIT with every 1% change in sales.

Guidelines for firms

General rule: Dont operate under condition of high DOL At high DOL small drop in sale leads to operating losses DOL magnifies impact of variable sales and variable production cost.

FINANCIAL LEVERAGE

Financial Leverage
Financial Leverage- ability of a firm to use fixed financial charges to magnify the effect of changes in EBIT on the earning per share. Financial leverage is employed in hope to increase the return to common stock holder.

COMPARISON
LEVERAGE Firms control OPERATING Not much FINANCIAL Considerable Effect on change in

sales
Magnifies Operating profit Leverage used on Fixed operating cost (associated with production)

Operating profit
Change in Earning per share Fixed financing cost (interest on debt)

Calculation of earning per share(EPS)

EPS = (EBIT I)(1-t)- PD . NS

Where, I = Annual interest paid on debt. PD = Annual dividend paid to preference share holders. t = Corporate tax rate. NS = Number of shares of common stock.

Example
Common stock No debt and no PS EBIT I EBT EBT*t(corporate tax) EAT PD EACS(earning available) NS EPS $ 2700000 $2700000 1080000 $1620000 $1620000 300000 $ 5.4 debt No PS Debt $ 5 M @ 12% $ 2700000 600000 $2100000 840000 $1260000 $1260000 200000 $6.30 Preferred stock No debt PS $ 5 M @ 11% $ 2700000 $2700000 1080000 $1620000 550000 $1070000 200000 $5.35

EBIT-EPS Chart
Preferred
6

Debt

Earnings per Share ($)

5 4 3 2 1 0 0

Common
Indifference point between preferred stock and common stock financing

Indifference point between debt and common stock financing

EBIT ($ thousands)

Indifference point
Indifference point: the point between two alternative where EPS is same. Away from the point either of the two will be preferable.

EBIT-EPS Chart
6

Debt
Indifference point between debt and common stock financing

Earnings per Share ($)

5 4 3 2 1 0 0

Common

100

200

300

400

500

600

700

EBIT ($ thousands)

Effect on RISK
Graph Safe distribution-negligible risk of EBIT falling below indifference point
Firm can go for debt financing to increase EPS

Risky distribution-considerable risk of EBIT falling below indifference point

Firm needs to be cautious to go for debt financing

GRAPHICAL EXPLANATION

DFL, Financial Risk and DTL

Degree of Financial Leverage

A quantitative measure of the sensitivity of a firms earnings per share to a change in the firms operating profit. Defining Value given by: DFL (at EBIT of X dollars) = % change in EPS % change in EBIT EPS= Earnings per share EBIT=Operating profit

Degree of Financial Leverage

Computing Value given by: DFL(EBIT of X dollars) = EBIT EBIT I [ PD / (1 - t ) ]

I = Annual Interest Paid PD = Annual preferred dividend paid t = corporate tax rate

DFL and Financial Risk

Financial Risk comprises of

possible insolvency In situation of inadequate cash Inadequate EPS

As a firm increases the proportion of fixed cost financing in its capital structure, fixed cash outflows increase. As a result, the probability of cash insolvency increases.

Example: financial risk

Assumption: expected EBIT = $ 80,000 and EBIT=$ 40000 , t=40%
Frame A : Forecast income statement information Expected EBIT Interest E[EBT] E[EBT] X t E[EACS] NS E[EPS] Frame B: Risk Components EPS CVEBIT=EBIT/E(EBIT) DFL $6.00 0.50 1.00 $12.00 0.50 1.60 Firm A (100% Equity) $80,000 --$80,000 32,000 $48,000 4,000 $12.00 Firm B (50% Equity) $80,000 30,000 $50,000 20,000 $30,000 2,000 $15.00

CVEPS=EPS/E(EPS)

0.50

0.80

Conclusion of the example

Total Risk = Financial Risk + Business Risk The coefficient of variation of EPS is a measure of total firm risk. It is given by: CV EPS = EPS / E(EPS) The coefficient of variation of EBIT is a measure of firmS Business risk. It is given by: CV EBIT = EBIT / E(EBIT) Difference of above two is Relative financial risk = CV EPS CV EBIT

HOW FIRM CAN CONTROL RISK WITHOUT COMPROMISING EPS.

BUSINESS RISK FINANCIAL RISK OVERALL RISK

LOW

HIGH

MEDIUM

HIGH

LOW

MEDIUM

MEDIUM

MEDIUM

MEDIUM

RISK MAGNIFYING EFFECT OF DFL

Total firm risk:= CV EBIT x DFL E(EBIT) = Business Risk X Financial Risk Thus, by applying financial leverage, DFL will magnify the impact of business risk on the variability of EPS. DFLs magnitude determines amount of additional risk induced by the use of financial leverage.

Total Leverage
It is the use of both fixed operating and fixed financing costs by the firm Thus it is the combination of both operating and financial leverage
Degree of Total Leverage

It is the quantitative measure of the total sensitivity of a firms earnings per share to a change in the firms sales

Degree of total leverage: formula

DTL is given by: DTL (at Q units or S dollars of sales) = % change in EPS

% change in sales
Computationally, DTL (at Q units or S dollars of sales) = DOL (at Q units or S dollars of sales) x DFL ( EBIT of X dollars) DTL (at Q units ) = Q(PV) Q(P V) FC I [PD / (1 - t )] DTL( S dollars of sales) = EBIT + FC EBIT I [PD / ( 1 - t )]

DTL and Total Firm Risk

Operating leverage and financial leverage can be combined in a no. of different ways to obtain a desirable degree of total leverage and level of total firm risk. High business risk can be offset with low financial risk and vice versa. The proper overall level of firm risk involves a tradeoff between total firm risk and expected return. This trade off must be made in keeping with the objective of maximizing shareholder value.

COVERAGE RATIOS & CASH INSOLVENCY

OPERATING AND FINANCIAL LEVERAGE

Why Coverage Ratio?

To analyze cash-flow ability of a firm to service fixed financial charges to determine the appropriate financial leverage for the firm. Debt capacity: It is maximum debt & other fixed charge financing that a firm can adequately service. If the expected future cash flows are higher and stable, then the debt capacity of firm will be higher.

Coverage ratios help in ascertaining the debt capacity.

Why Coverage Ratio? (cont.)

The fixed financial charges must be met with cash which may otherwise lead to cash insolvency.

Includes
Principal payments on debt Interest payments on debt Financial lease payments, etc

Coverage Ratios

OPERATING AND FINANCIAL LEVERAGE

In computation of coverage ratios, EBIT is used as a rough measure of cash flow available to cover fixed financial charges Types of Coverage ratios: Interest Coverage Ratio Debt-Service Coverage Ratio

Interest Coverage Ratio

Interest Coverage Ratio(ICR) =

EBIT Interest Expenses

ICR of 1 indicates that the earnings are just sufficient to satisfy the interest burden without any cushion for change in EBIT.

No generalization. ICR at the most can be industry specific.

If the business is highly stable- Low ICR

Highly cyclical businesses High ICR

Limitation of ICR:- Does not account for debts principle service.

Debt-Service Coverage RatioOvercoming ICR Limitation

Debt-Service Coverage Ratio
EBIT Interest Expenses + Principal payments 1 Tax Rate

The debt-service burden may be defined as the cash required to meet the interest expenses & principal payments. If for example the Debt-Service Coverage Ratio is 2, then even if EBIT falls to 50% , the firm will meet interest and principal payments liability.

Probability of Cash Insolvency

The vital question for a firm
is not so much whether a coverage ratio will fall below 1 But what are the chances of cash insolvency.

Cash Insolvency
It helps us assess that if all the sources of payments like
Expected earnings Cash flow factors such as purchase or sale of assets liquidity of the firm dividend payments seasonal patterns

are collectively sufficient or deficient to meet these fixed obligation.

If the probability is low it implies that an additional cash drain may cause cash insolvency.

Surveying Investment Analysts and Lenders

As the investment analysts, investors and investment bankers are in the business of recommending stocks, it is advisable to obtain their views on the appropriate amount of financial leverage. They are able to explain the market prospects with respect to financial leverages

THANK YOU