The Concept of Leverage

And
Leverage Analysis
The Concept of Leverage
Leverage and its Meaning
• Leverage
• the use of fixed costs in an attempt to increase (or
lever up) profitability.
• Leverage in Physics
• lifting heavy weight with a small force
• Leverage in Politics
• mobilizing many people with few words
• Leverage in Finance
• changing profit significantly with slight change
in sales 2
Types of Leverage

• Operating leverage:
• the use of fixed operating costs by the firm
• present anytime a firm has fixed operating
cost-regardless of volume
• Financial leverage (Gearing):
• the use of fixed costs of financing by the firm
• acquired by choice

3
Operating Leverage
• analysis involves the short-run as all costs are
variable in the long-run
• a change in the volume of sales results in a more
than proportional change in the operating profit
(or loss) as a lever used to magnify a force applied
at one point into a larger force at some other point
• a measure of the effect of change in sales on EBIT
• a measure of operating risk and arise from fixed
operating costs
4
 Effect of Operating Leverage: Example
Firm A Firm B Firm C
Sales Br. 10,000 Br. 11,000 Br. 19,500
Operating Costs:
Variable 2,000 7,000 3,000
Fixed 7,000 2,000 14,000
Operating Profit (EBIT) Br. 1,000 Br. 2,000 Br. 2,500
OL Ratios:
FC/TC .78 .22 .82
FC/Sales .70 .18 .72
5
• If sales increases by 50%, % change in EBIT = ?
 Effect of Operating Leverage …
• If sales  by 50%, %  in EBIT would be:
Firm A Firm B Firm C
Sales Br. 15,000 Br. 16,500 Br. 29,250
Operating Costs:
Variable 3,000 10,500 4,500
Fixed 7,000 2,000 14,000
Operating Profit (EBIT) Br. 5,000 Br. 4,000 Br. 10,750
%  in EBIT:
EBITt – EBITt-1
 100% 400% 100% 330%
EBITt-1
6
The most sensitive firm
Break-Even Analysis
• a technique for studying the relationships among
fixed costs, variable costs, profits, and sales
volume.
• Break-even Point (BEP) Quantity :
• the point (quantity of outputs produced & sold)
where total revenues equal to total operating costs
or operating profit (EBIT) equals to zero.
 EBIT = PQ – VQ – F = (P – V)Q – F
 At BEP (QBE), EBIT = 0
 Therefore, (P – V)QBE – F = 0
7
 QBE = F/(P – V)
Example: Break-Even Point (BEP)
Quantity
• A firm producing & selling a bicycle helmet for
Br. 50 a unit. The firm‟s annual fixed operating
costs are Br. 100,000, & variable operating costs
are Br. 25 a unit regardless of the volume sold.
What is the BEP Quantity?
• QBE = F/(P – V)
• QBE = Br. 100,000  (Br. 50 – Br. 25)
• QBE = Br. 100,000  Br. 25
• QBE = 4,000units
8
Break-Even Chart
Revenue & Cost
(„000)
Total Revenue
Total Cost

300 Profit

Variable Cost
200
BEP

Loss
100 Fixed Cost

0 9
4,000 Quantity
Degree of Operating Leverage (DOL)

• A quantitative measure of the sensitivity of a

firm‟s operating profit to a change in the firm‟s
sales
• The percentage change in a firm‟s EBIT resulting
from a 1% change in output (sales)
% Δ in EBIT
DOL @ Q Units of Output 
% Δ in Sales
Q
DOL@ Q Units 
Q - QBE
S  VC EBIT  F
DOLS Birr of Sales  
S  VC  F EBIT 10
Example: DOL
• From the previous BEP Example; P = Br. 50, V = Br. 25 &
F = Br. 100,000. Find the following:
• DOL@5,000units
• DOL@6,000units
• DOL@7,000units
• DOL@3,000units
Q 5,000 5,000
DOL@ 5,000units    5
Q - QBE 5,000  4,000 1,000
6,000 6,000
DOL@ 6,000units   3
6,000  4,000 2,000
7,000 7,000
DOL@ 7,000units    2.33
7,000  4,000 3,000
11
3,000 3,000
DOL@ 3,000units    -3
3,000  4,000 - 1,000
DOL & the Break-Even Point

DOL

5
4
3
2
1
0
4,000 Quantity
-1

-2
-3

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Financial Leverage (Gearing)

• Involves the use of fixed cost financing

• Is employed in the hope of increasing the return
to common stockholders
• In effect, it is the second step in a two-step
profit magnification process
• In step 1, OL magnifies the effect of  in sales
on  in operating profit
• In step 2, the financial manager has the option
of using gearing to further magnify the effect of
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any resulting  in EBIT on  in EPS
EBIT-EPS Break-Even, or
Indifference, Analysis
• Analysis of the effect of financing alternatives
on EPS
• Indifference point:
• The break-even (or EBIT-EPS indifference) point
• The level of EBIT that produces the same level of
EPS for two (or more) alternative capital
structures
• Earnings per share (EPS):
EBIT−I 1−𝑡 −PD
• EPS = 14
NS
Example: Indifference Analysis
• Cherokee Co., with a Br.10million C/S equity
financing entirely, wishes to raise another Br.5million
for expansion through one of three possible financing
plans. Currently, tax rate =40%, 200,000 shares
outstanding, & annual EBIT = Br.1.5million; but, with
expansion = Br.2.7million.
• The company may gain additional financing with a
new issuance of:
1. All C/S (100,000 additional shares @ Br.50 a share)
2. All Debt @ 12% interest, or
3. All P/S (100,000 @ 11% Fixed Dividends)
15
• Required: Determine the Indifference Points
 EPS under 3 Additional Financing
Common Preferred
Debt
Stock Stock
EBIT 2,700,000 2,700,000 2,700,000
Less: Interest - 600,000 -
EBT 2,700,000 2,100,000 2,700,000
Less: Tax (t  EBT) 1,080,000 840,000 1,080,000
EAT 1,620,000 1,260,000 1,620,000
PD - - 550,000
EACS 1,620,000 1,260,000 1,070,000
NS 300,000 200,000 200,000 16

EPS 5.40 6.30 5.35

Indifference Points
• Indifference point between C/S (1) & Debt (2):
EBIT1,2 − I1 1−𝑡 −PD1 EBIT1,2 − I2 1−𝑡 −PD2
• =
NS1 NS2

EBIT1,2 0.6 EBIT1,2 −600,000 0.6

• =
300,000 200,000

• EBIT1,2 = 𝐁𝐫. 𝟏, 𝟖𝟎𝟎, 𝟎𝟎𝟎

1,800,000 0.6
• EPS1,2 = = Br. 3.60
300,000 17
Indifference Points
• Indifference point between C/S (1) & P/S (3):
EBIT1,3 − I1 1−𝑡 −PD1 EBIT1,3 − I3 1−𝑡 −PD3
• =
NS1 NS3

EBIT1,3 0.6 (0.6) EBIT1,3 −550,000

• =
300,000 200,000

• EBIT1,3 = 𝐁𝐫. 𝟐, 𝟕𝟓𝟎, 𝟎𝟎𝟎

2,750,000 0.6
• EPS1,3 = = Br. 5.50
300,000 18
EBIT-EPS Break-Even, or
Indifference, Chart
EPS (Br.)
Debt P/S
7 C/S
6
5
(2,750,000; 5.50)
4
3
(1,800,000; 3.60)
2
1
0 19
1 2 3 4
EBIT (Br. Millions)
Effect on Risk
• So far, EBIT-EPS Analysis is on return (EPS)
• An EBIT-EPS Chart does not permit a precise
analysis of risk
• Nevertheless, certain possible generalizations:
• The higher the Exp. Level of EBIT exceeding the
Indifference Point, the stronger the case for debt
financing
• Assess likelihood of future EBITs falling below the
point
• Possible fluctuations in EBIT from expected:
• EBIT > I.P & Pr.(EBITs < I.P) = Low  Debt = SAFE
20
• EBIT > I.P & Pr.(EBITs < I.P) = High  Debt = RISKY
 EBIT-EPS Indifference Chart & EBIT
Probability Distribution

(for the probability distribution)

.

Probability of Occurrence
Debt
C/S
EPS (Br.)

SAFE
Indifference
Point

RISKY

0
0 21
EBIT (Br. Thousands)
Degree of Financial Leverage (DFL)
• A quantitative measure of the sensitivity of a
firm‟s EPS to a change in the firm‟s operating
profit (EBIT)
• The percentage change in EPS over the percentage
change in operating profit that causes the change
in EPS
% Δ in EPS
DFL@ EBIT of X Br. 
% Δ in EBIT

EBIT
DFL@ EBIT of X Br. 
PD
EBIT - I - [ ] 22
(1 - t)
 Example: DFL
• From the previous Financing Alternatives Example;
Find the DFL@EBIT of Br. 2.7million for the:
1. Debt Financing
2. P/S Financing
EBIT
DFL@ EBIT of X Br. 
PD
EBIT - I - [ ]
(1 - t)
2,700,000
1. DFL@ EBIT of Br. 2.7million   1.29
0
2,700,000 - 600,000 - [ ]
(1 - 0.4)

2,700,000
2. DFL@ EBIT of Br. 2.7million   1.51
550,000
2,700,000 - 0 - [ ] 23
(1 - 0.4)
Total Leverage

• The effect of combining financial and operating

leverages is a two-step magnification of any
changes in sales into a larger relative change in
EPS
• A quantitative measure of total sensitivity of a
firm‟s EPS to a change in the firm‟s sales
% Δ in EPS
DTL@ Q Units of Sales 
% Δ in Sales

DTL = DOL  DFL 24

Effects of Leverage
• DOL & Business Risk
• DOL is only one component of the overall business
risk of a firm
• Business risk: Inherent uncertainty in the physical
operations of a firm
• Other principal factors include the variability in
sales and production costs
• DOL:
• Magnifies the variability of EBIT and, hence, the
firm‟s business risk
• Measure of “potential risk” becomes “active” only in 25
the presence of sales & production cost variability
Effects of Leverage…
• DFL & Financial Risk
• Encompasses both the added variability in EPS
plus the risk of possible insolvency-that is
induced by the use of financial leverage
• 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
26
Effects of Leverage…
Total Firm Risk = Business Risk + Financial Risk
σEPS
CVEPS = Measure of relative
Exp(EPS) Total Firm Risk

σEBIT
CVEBIT = Measure of relative
Exp(EBIT) Business Risk

CVEPS − CVEBIT = 𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐑𝐢𝐬𝐤

27
Chapter
Ends

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