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# Chapter Five Leverage and Capital Structure

Allen

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Learning Goals
1. Discuss role of breakeven analysis in leverage study, determine operating breakeven point (OBEP), and effect of changing production/sales on breakeven point. 2. Understand 3 Leverages
Degree of Operating Leverage (DOL) Degree of Financial Leverage (DFL) Degree of Combined Leverage (DCL/DTL/DGL)

3. Able to calculate DOL, DFL and DCL (DTL or DGL) as well as to implement sensitivity (indifference point of EBITs) and risk analysis. 4. Understand the implications of different leverages.
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1. Breakeven Concept
Breakeven Analysis is used by firms:
To determine the level of operations necessary to cover all operating costs, variable cost and fixed cost, and To evaluate the profitability associated with various levels of sales.

## Operating Break-Even Point (BE) at different points,

Economic Breakeven: EBIT = 0 Financial Breakeven: EBT = 0 Accounting Breakeven: NITA = 0
Questions #1 and #2

Business Risk: how is cost structured, variable and fixed costs Financial Risk: how business is financed, debt or equity

Operating leverage: how capital assets are employed Financial leverage: how the amount of debts are utilized
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\$
Because the slope of Revenue > the slope of Total Cost, therefore total cost increases at slower speed when revenue increases,,

Revenue

S
At breakeven point Q*: Total revenue S* = total cost (TC) = TFC + TVC.
Breakeven point

Total Cost

At point Q: Total revenue S > total cost (TC) which is a sum of TFC and TVC. S > TC = TFC+TVC

S*
Variable Cost Fixed Cost

Q*
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Q
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Time
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Breakeven Output
Operating Profit = (P Q) (VC Q) FC
PQ=? VC Q = ? FC = ? To determine operating breakeven point at quantity Q*:

>0 =0 <0

## Operating Profit = 0 = (P Q*) (VC Q*) FC

Q* = [FC /(P VC)] or using BA II plus calculator FC = fixed operating cost per period VC = variable operating cost per unit P = sales price per unit Questions #3 p140 PFT = \$0.00 Q* is quantity at BE point, Profit = 0 . EBIT = earnings before interest and taxes = Operating Profit
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Allen

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Allen

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## Re-visit Income Statement

Operating Section
Sales revenue (Price multiplies units produced): Less: Cost Of Good Sold as (Variable Cost) Cross margin Total operating expenses as (Fixed Cost) Operating (income/profit) earnings (EBIT) \$11 \$9 \$5 \$4 \$0 \$0.8 \$3.2
\$1.28

\$ billion \$20

## Financial (Non-Operating) Section

Other income Less interest expenses (Financial cost) Earning (income) before tax

Owner Section
Less taxes (rate 40%) Net income after tax (NIAT) \$1.92

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Income Statement
Operating Leverage

Total Leverage

Financial Leverage

Sales Revenue S = (P Q) Less: Variable operating cost (VC Q) Cost Gross margin Q (P VC) Structure Less: Fixed operating cost (FC) EBIT (operating margin) Q(P-VC) - FC Less: Interest expense EBT: (EBIT Interest cost) Less: Taxes Financial NIAT (profit margin) Structure Less: Preferred share dividends Earnings available for common shareholders (EAC) Earnings per share (EPS) Income Statement with VC and FC
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2. Operating Leverage
Operating leverage is the use of fixed operating costs (as a leverage) to magnify the effects of changes in sales (production, Q) on the firms earnings before interest and taxes (EBIT). When fixed operating costs is flat, the more you produce, the higher EBIT you obtain, assuming the price and VC/unit remain unchanged. See next slide, from EBIT0 to EBIT1 and then EBIT2 at different outputs of Q Change with quantity, Q*, produced
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## Measuring the Degree of Operating Leverage

Degree of Operating Leverage (DOL) is the numerical measure of a firms operating leverage at a base level (year) of sales.
( P Q ) ( Q VC ) DOL @ base level Q = ( P Q ) ( Q VC ) FC

The equation can be simplified (from income statement) as the ratio of the dollar value of gross margin over EBIT. DOL at base level (year) of Q is
TR TVC Sales Revenue TVC GM \$ DOL = = = TR TVC FC Sales Revenue TVC TFC EBIT
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3. Financial Leverage
Financial Leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on the firms earnings per share, EPS. Two fixed financial costs can be identified in the income statement are: Interest on long-term debt, and Preferred share dividends. What about taxes?
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Sales Revenue (P * Q) Less: COGS (VC * Q) Gross margin Less: Operating cost (FC) EBIT (operating margin) Less: Interest exp. & Taxes NIAT (profit margin) Less: Preferred share divid. EAC Earnings per share (EPS)
Financial Leverage
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## Measuring the Degree of Financial Leverage

Degree of Financial Leverage (DFL) is the numerical measure of the firms financial leverage.

I PD T
PD 1T
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## = interest on debt = preferred shares dividends = corporate tax rate in percentage

= converts after-tax preferred share dividends into beforetax amount to keep consistency with the other terms.
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## 4. Degree of Combined Leverage

Degree of Total Leverage is the application of fixed costs, both operating and financial costs, to magnify the direct effect from changes in sales to/on the firms earnings available for common shareholders (EAC) or earnings per share (EPS). Degree of Total Leverage (DOL) is a combined effect of Operating Leverage (DCL) and Financing Leverage Degree of Total Leverage is total impact of the fixed costs in the firms operating structure and financial structure on EPS. Degree of Total Leverage gives you direct answer from change of sales to change of EPS.
Question # 9 of page 141 and #11 of page 142
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Operating Leverage
Operating leverage is the use of fixed operating costs (as a leverage) to magnify the effects of changes in sales (production, Q) on the firms earnings before interest and taxes (EBIT). When fixed operating costs is flat, the more you produce, the higher EBIT you obtain, assuming the price and VC/unit remain unchanged. See next slide, from EBIT0 to EBIT1 and then EBIT2 at different outputs of Q Change with quantity, Q*, produced
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Breakeven Analysis

TVC* = \$2,500
11 11 11 1

TC* = \$5,000

TFC = \$2,500

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Sensitivity Analysis

Questions #5

EBIT2

## EBIT1 , EBIT* Variable Cost

Q*
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Q1

Q2
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Question
TR TVC Sales TVC GM \$ DOL = = = TR TVC FC Sales TVC TFC EBIT
1. Should DOL be greater than 1 or equal to 1 or less than 1? 2. What does it mean when DOL = 1? 3. Can DOL equal to zero, DOL = 0? 4. What happens if DOL is zero?
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Example of DOL
XYZ has fixed operating costs of \$86,000, variable operating costs of \$5.48/unit, and a selling price of \$8.98/unit. (use your calculator). A) Calculate the operating breakeven point in units B) Compute the DOL for the following unit sales: 25,000; 30,000; and 40,000 C) Graph the DOL figures that you computed in B) (on the y axis) against sales levels (on x axis). D) Compute the degree of operating leverage at the point of breakeven units; add this point to your graph. E) what principle is illustrated by your graph and figure? DOL Example
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## Answers to Example of DOL

FV Price VC Breakeven Point DOL at 25,000 DOL at 30,000 DOL at 40,000 DOL at breakeven
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## DOL 58.3.0 5.50 2.60

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DOL 50 40 30 25 20 15 10 5 0 15,000
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DOL curve

Breakeven point
20,000 25,000
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## Predict EBIT from base level/year

Operating Section
Sales revenue (Price multiplies units produced): Less: Cost Of Good Sold as (Variable Cost) Cross margin Total operating expenses as (Fixed Cost) Operating (income/profit) earnings (EBIT) \$11 \$9 \$5 \$4 \$0 \$0.8 \$3.2
\$1.28

\$ billion \$20

## Financial (Non-Operating) Section

Other income Less interest expenses (Financial cost) Earning (income) before tax

Owner Section
Less taxes (rate 40%) Net income after tax (NIAT) \$1.92

What are DOL and DFL? If POS = 15%, what is EBIT and Net Income in next year
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Limitation s of DOL
1. Revenue and cost are linear function of volume changes. 2. Focusing on limited time period. 3. Not accounting for the timing of cash flows; 4. Limited by Opportunity cost of an investment; 5. Without considering changes in marketplace and new products
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Profit

Loss

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## DOL is Double-Edged Sword

A leveraged firm (highly leveraged in capital assets) has high fixed costs, a high Break-Even point and high DOL. A conservative (non-leveraged or less leveraged) firm has low fixed costs, a low Break-Even point and low DOL. Leverage is a double-edged sword. It magnifies losses as well as profits implications. Relationship between risk and returns.
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## Summary of Measuring DOL

1. Degree of Operating Leverage (DOL): For any given level of fixed assets, Any changes () in sales will produce Magnified changes () in EBIT. Sales change by a percentage, EBIT will change by a greater percentage. Normally DOL > 1. As long as DOL > 1, there is operating leverage. At breakeven point, DOL = The higher the firms fixed operating cost relative to variable operating costs (distance btw FC and VC), the greater the degree of operating leverage. In application, DOL can be used in current year and/or as base year to identify futures EBIT if sales revenue is predicted DOL can be used in conjunction with sales forecasting and Pro Forma statements The higher DOL, the greater the impacts that sales change have on EBIT. but higher levels of DOL also imply greater operating risk Why?
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2. 3. 4.

5.

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3. Financial Leverage
Financial Leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on the firms earnings per share, EPS. Two fixed financial costs can be identified in the income statement are: Interest on long-term debt, and Preferred share dividends. What about taxes?
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Sales Revenue (P * Q) Less: COGS (VC * Q) Gross margin Less: Operating cost (FC) EBIT (operating margin) Less: Interest exp. & Taxes NIAT (profit margin) Less: Preferred share divid. EAC Earnings per share (EPS)
Financial Leverage
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## Measuring the Degree of Financial Leverage

Degree of Financial Leverage (DFL) is the numerical measure of the firms financial leverage.

I PD T
PD 1T
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## = interest on debt = preferred shares dividends = corporate tax rate in percentage

= converts after-tax preferred share dividends into beforetax amount to keep consistency with the other terms.
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## EBIT/EPS Indifference Point

The level of EBIT at which alternative financing plans yield the same earnings per share (EPS) Mathematically,
( EBIT * I A ) (1 T ) ( EBIT * I B ) (1 T ) = SA SB SB I A S A I B EBIT * = SB S A
EBIT* = Operating income at the indifferent points; I = Interest Expenses under plan A or Plan B S = Number of shares outstanding under Plan A or Plan B T = Corporate tax rate. Questions #16 on p143
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## 4. Degree of Combined Leverage

Degree of Total Leverage is the application of fixed costs, both operating and financial costs, to magnify the direct effect from changes in sales to/on the firms earnings available for common shareholders (EAC) or earnings per share (EPS). Degree of Total Leverage (DOL) is a combined effect of Operating Leverage (DCL) and Financing Leverage Degree of Total Leverage is total impact of the fixed costs in the firms operating structure and financial structure on EPS. Degree of Total Leverage gives you direct answer from change of sales to change of EPS.
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## Combining operating and financial leverage

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DCL implications
DCL @ base level Q = GM \$ PD EBIT I 1T

## GM \$ DCL @ base level Q = PD EBT 1T

> 1 ? Why and what does that imply ? Should DCL be = 1 ? Why and what does that imply ? < 1 ? Why and what does that imply ?
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Example of DCL
Firm X has sales of 100,000 units at \$2/unit, VOC of \$1.70/unit, and FOC of \$6,000. Interest cost is \$10,000/year. Firm Y has sales of 100,000 units at \$2.5/unit, VOC of \$1/unit. FOC of \$62,500. Interest cost is \$17,500/year. Assume the both firms are in the 40% tax bracket. A) Compute the DOL, DFL and DCL for Firm X. Explain the implications of your answers. B) Compute the DOL, DFL and DCL for Firm Y. Explain the implications of your answers. C) Compare the relative risks of the two firms D) Discuss the principles of leverage illustrated in your answers.
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Summary of Information
VOC X Y \$1.70 \$1.00 FOC \$6,000 Price \$2.00 Q S I Tax 100,000 \$200,000 100,000 \$250,000
X Sales Revenue Total variable cost (TVC) Gross Margin in dollars \$ Total fixed cost (TFC) EBIT Interest payment I Earning before Taxes (EBT) Taxes amount @ 40% EAC
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## \$10,000 40% \$17,500 40%

Y \$250,000 \$100,000 \$150,000 \$62,500 \$87,500 \$17,500 \$70,000 \$28,000 \$42,000
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\$62,500 \$2.50

## \$200,000 \$170,000 \$30,000 \$6,000 \$24,000 \$10,000 \$14,000 \$5,600 \$8,400

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X Y DOL 1.25 1.71 DFL 1.71 1.25 DCL 2.14 2.14

C) Firm X has less operating (business) risk but more financial risk than Firm Y. D) Two firms with differing operating and financial structures may be equally leveraged. Since total leverage is the product of operating and financial leverages, each firm may structure itself differently and still has the same amount of total risk.
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## Example of application of leverages

XYZ Inc. sold it products at \$6/unit. VOC is \$3.50/unit and FOC is \$50,000/year. Interest cost is \$13,000 and \$7,000 of preferred share dividends each year. At this point, XYZ Inc. is selling 30,000 units/year and is taxed at 40%. A) Calculate XYZ Inc.s Operating breakeven point in units and sales dollars; B) Based on the XYZ Inc.s current sales of 30,000 units per year and its interest and preferred dividends costs, Calculate its EBIT and EAC; C) Calculate XYZ Inc.s DOL, DFL and DCL. Explain your answers. D) XYZ Inc. has entered into a contract to produce and sell an additional 15,000 units in the coming year. Use the DOL, DFL and DCL to predict and calculate the changes in EBIT and EAC.
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A) Breakeven Units and Revenue
Q* = FC (P - VC) = \$50,000 (\$6 - \$3.50) = 20,000 units S* = Breakeven quantity price/unit = 20,000 \$6 = \$120,000 B) EBIT and EAC Sales (\$6 30,000) Less: Variable costs (\$3.50 30,000) Fixed costs EBIT Less interest expense EBT Less taxes (40%) NIAT Less: Referred Dividends EAC
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\$180,000 105,000 50,000 25,000 13,000 12,000 4,800 \$7,200 \$7,000 \$200
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C) 30,000 units 45,000 units DOL 3.0 1.8 DFL 75.08 1.65 DCL 225.24 2.97

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1) % Change in EBIT = % Change in sales DOL = 50% 3 = 150% New EBIT = \$25,000 + (\$25,000 150%) = \$62,500

2) % Change in EAC
= % Change in sales DCL = 50% 225.24 = 11,262% New EAC = \$200 + (\$200 11,262%) = \$200 + \$22,524 = \$22,724 (vs. \$22,700)
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## D: another way to present

Sales (in units): Sales revenue: Less: Variable operating costs Less: Fixed operating costs EBIT: Less: Interest Expense EBT Less: Taxes (40%) financial structure
Cost structure

+50%

## \$25,000 +150% \$62,500 \$13,000 \$12,000 \$4,800 \$13,000 \$49,500 \$19,800

NIAT
Preferred Dividends EAC
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\$\$7,200
\$7,000 \$200
+11,250%

\$29,700
\$7,000 \$22,700
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