Chapter 5

Operating and Financial

Leverage
Chapter 5 - Outline LT 5-1

 What is Leverage?
 Break-Even (BE) Point

 Operating Leverage

 Financial Leverage

 Leverage Means Risk

 Combined or Total Leverage

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What is Leverage? LT 5-2

Leverage is using fixed costs to magnify the potential return

to a firm

2 types of fixed costs:

– fixed operating costs = rent, depreciation
– fixed financial costs = i costs from debt

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Leverage Means Risk LT 5-6

 Leverage is a double-edged sword

 It magnifies profits as well as losses
 An aggressive or highly leveraged firm has high fixed costs
(and a relatively high break-even point)
 A conservative or non-leveraged firm has low fixed costs
(and a relatively low break-even point)
 Many Japanese firms tend to be highly leveraged

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Break-Even (BE) Point LT 5-3

 Quantity where Total Revenue equals Total Cost

 Company has no Profit or Loss
 BE = Fixed Costs / (Price – Variable Costs)
 A leveraged firm has a high BE point
 A non-leveraged firm has a low BE point

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Operating Leverage LT 5-4

 Measure of the amount of fixed operating costs used by a

firm
 Degree of Operating Leverage (DOL) = %age  in EBIT (or
OI) / %age  in Sales
 a  in Sales  a larger  in EBIT (or OI)
 Operating Leverage measures the sensitivity of a firm’s
operating income to a  in sales

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 PPT 5-2
TABLE 5-2
Volume-cost-profit analysis: Leveraged firm

Price/Unit $ 2.00
VC / Unit $ 0.80
Total Operating
Variable Fixed Total Income
Units Sold Costs Costs Total Costs Revenue (Loss)
- $ - $ 60,000 $ 60,000 $ - (60,000)
20,000 $ 16,000 $ 60,000 $ 76,000 $ 40,000 (36,000)
40,000 $ 32,000 $ 60,000 $ 92,000 $ 80,000 (12,000)
50,000 $ 40,000 $ 60,000 $ 100,000 $ 100,000 -
60,000 $ 48,000 $ 60,000 $ 108,000 $ 120,000 12,000
80,000 $ 64,000 $ 60,000 $ 124,000 $ 160,000 36,000
100,000 $ 80,000 $ 60,000 $ 140,000 $ 200,000 60,000

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FIGURE 5-1
Break-even
chart:
Leveraged
firm

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 PPT 5-4
TABLE 5-3
Volume-cost-profit analysis: Conservative firm

Price/Unit $
2.00
VC / Unit $
1.60
Total Operating
Variable Fixed Total Income
Units Sold Costs Costs Total Costs Revenue (Loss)
- $ - $ 12,000 $ 12,000 $ - (12,000)
20,000 $ 32,000 $ 12,000 $ 44,000 $ 40,000 (4,000)
30,000 $ 48,000 $ 12,000 $ 60,000 $ 60,000 -
40,000 $ 64,000 $ 12,000 $ 76,000 $ 80,000 4,000
60,000 $ 96,000 $ 12,000 $ 108,000 $ 120,000 12,000
80,000 $ 128,000 $ 12,000 $ 140,000 $ 160,000 20,000
100,000 $ 160,000 $ 12,000 $ 172,000 $ 200,000 28,000

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FIGURE 5-2 5-3
Break-even
chart:
Conservative
firm

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 PPT 5-5
TABLE 5-4
Operating income or loss

Units Leveraged Conservative

Sold Firm Firm
- (60,000) (12,000)
20,000 (36,000) (4,000)
40,000 (12,000) -
50,000 - 4,000
60,000 12,000 12,000
80,000 36,000 20,000
100,000 60,000 28,000

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Financial Leverage LT 5-5

 Measure of the amount of debt used by a firm

 Degree of Financial Leverage (DFL) = %age  in EPS / %age
 in EBIT (or OI)
 a  in EBIT (or OI)  a larger  in EPS
 Financial Leverage measures the sensitivity of a firm’s
earnings per share to a  in operating income

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $0.00

Plan A Plan B
(Leveraged) (Conservative)
Earnings before Interest and taxes (EBIT) $0 $0
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) ($12,000) ($4,000)
Less Taxes (T) (assume 50%) $6,000 $2,000
equals Earnings Before Taxes (EBT) ($6,000) ($2,000)
divided by No. of Shares Outstanding $8,000 $24,000
equals Earnings Per Share (EPS) ($0.750) ($0.083)

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $12,000.00

Plan A Plan B
(Leveraged) (Conservative)
Earnings before Interest and taxes (EBIT) $12,000 $12,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $0 $8,000
Less Taxes (T) (assume 50%) $0 ($4,000)
equals Earnings Before Taxes (EBT) $0 $4,000
divided by No. of Shares Outstanding $8,000 $24,000
equals Earnings Per Share (EPS) $0.000 $0.167

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $16,000.00

Plan A Plan B
(Leveraged) (Conservative)
Earnings before Interest and taxes (EBIT) $16,000 $16,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $4,000 $12,000
Less Taxes (T) (assume 50%) ($2,000) ($6,000)
equals Earnings Before Taxes (EBT) $2,000 $6,000
divided by No. of Shares Outstanding $8,000 $24,000
equals Earnings Per Share (EPS) $0.250 $0.250

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $36,000.00

Plan A Plan B
(Leveraged) (Conservative)
Earnings before Interest and taxes (EBIT) $36,000 $36,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $24,000 $32,000
Less Taxes (T) (assume 50%) ($12,000) ($16,000)
equals Earnings Before Taxes (EBT) $12,000 $16,000
divided by No. of Shares Outstanding $8,000 $24,000
equals Earnings Per Share (EPS) $1.500 $0.667

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $60,000.00

Plan A Plan B
(Leveraged) (Conservative)
Earnings before Interest and taxes (EBIT) $60,000 $60,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $48,000 $56,000
Less Taxes (T) (assume 50%) ($24,000) ($28,000)
equals Earnings Before Taxes (EBT) $24,000 $28,000
divided by No. of Shares Outstanding $8,000 $24,000
equals Earnings Per Share (EPS) $3.000 $1.167

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 5-8

TABLE 5-5
Impact of Financing plan on earnings/share

EPS Plan A EPS Plan B

Earnings before Interest and taxes (EBIT)
(Leveraged) (Conservative)
$0 ($0.75) ($0.08)
$12,000 $0.00 $0.17
$16,000 $0.25 $0.25
$36,000 $1.50 $0.67
$60,000 $3.00 $1.17

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 PPT 5-7
FIGURE 5-4
Financing plans
and
earnings
per share

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Combined or Total Leverage LT 5-7

 Represents maximum use of leverage

 Degree of Combined or Total Leverage (DCL or DTL) = %age
 in EPS / %age  in Sales
 a  in Sales  a larger  in EPS
 Short-cut formula:
DCL or DTL = DOL x DFL

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TABLE 5-6 PPT 5-9
Income statement

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 PPT 5-10
FIGURE 5-5
Combining
operating
and financial
leverage

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