FINANCIAL MANAGEMENT:

THE CONCEPT OF LEVERAGE

BUSINESS AND FINANCIAL RISKS

OPERATING LEVERAGE
a measure of operating risk that refers to the FIXED OPERATING COSTS found in the
INCOME STATEMENT.

it is the DEGREE to which a firm uses FIXED COSTS in its production process

CM ∆ % in EBIT
DOL =
DEGREE OF OPERATING LEVERAG = EBIT OR ∆ % in Sales
(DOL)

v    A high DOL means that a relatively small change in Sales will result in a large
change in pre-tax operating income

v    The higher the firm's DOL, the higher is the firm's business risk

FINANCIAL LEVERAGE

a measure of financial risk that refers to financing a portion of the firm's assets,
bearing fixed financing chanrges in hopes of increasing the return of the common
stockholders

it refers to the firm's use of fixed charge securities such as debt and preferred stock
in its capital structure

EBIT ∆ % in EPS
DFL =
DEGREE OF FINANCIAL LEVERAGE = EBIT-FFC OR ∆ % in EBIT
(DFL)

FFC = fixed financing charges: Interest charges + pre-tax preferred dividends

v    The higher the firms DFL, the higher is the firm's financial risk

v    If the assets in which funds are invested are able to earn a Rate of Return (ROR) greater
than the ROR required by the fund's source, then there is positive financial leverage,
and the common stockholders therefore also benefit.

In this case, the return on common stockholders' equity is greater than the return on
assets.

TOTAL LEVERAGE
the measure of total risk determined by combining the effects of both the financial
abd operating leverage
 it is also known as the degree of combined leverage

CM ∆ % in EPS
DTL =
DEGREE OF TOTAL LEVERAGE = EBIT-FFC OR ∆ % in Sales
(DTL)

DTL = = DOL x DFL

FFC = fixed financing charges: Interest charges + pre-tax preferred dividends

CASH BREAK-EVEN POINT

If the opportunity cost of holding excess cash is high, management may want to know
the volume of sales that will sover all cash expenses during a period.

This is known as the cash break-even point

This is computed based on the factthat not all fixed operating costs involve
CASH PAYMENTS

CW 14 - LEVERAGE

CASH BREAK-EVEN POINT AND LEVERAGE

DAN COMPANY sells soaps for P 1.20 each. The unit Variable Cost is P 1.00 while the
Fixed operating costs amounted to P 50,000. The company has current interest charges
of P 6,000 and preferred dividends of P 2,400. The corporate tax rate is 40%

REQUIRED:
1. Cash Break-even point in units (if fixed depreciation charges is P 20,000
SOLUTION:
BREAK-EVEN POINT (UNIITS) = (Fixed cost - Depreciation expenses) / Contribution Margin
= (50,000 - 20,000/(1.20 - 1.00)
= 30,000/0.20
= 150,000 units

2. Assuming that Dan sold 500,000 soaps for a year, compute:

A. Degree of operating Leverage (DOL)
SOLUTION:
SALES(1.20 X 500,000) 600,000
LESS: VARIABLE COST(1.00 X 500,000) -500,000
CONTRIBUTION MARGIN 100,000
FIXED COST -50,000
OPERATING INCOME 50,000
TAX RATE(40%) 20,000
INTEREST 6,000
EBIT 76,000

DOL=CM/EBIT
= 100,000/76,000
= 1.3158

B Degree of financial leverage (DFL)

SOLUTION:
SALES(1.20 X 500,000) 600,000
LESS: VARIABLE COST(1.00 X 500,000) -500,000
CONTRIBUTION MARGIN 100,000
FIXED COST -50,000
OPERATING INCOME 50,000
INTEREST 6,000
TAX RATE(40%) 20,000
EBIT 76,000

DFL= EBIT/(EBIT-FFC)
= 76,000/(76,000 - 8,400)
= 76,000/67,600
= 1.1243

C. Degree of total leverage (DTL)

SOLUTION:
SALES(1.20 X 500,000) 600,000
LESS: VARIABLE COST(1.00 X 500,000) -500,000
CONTRIBUTION MARGIN 100,000
FIXED COST -50,000
OPERATING INCOME 50,000
INTEREST 6,000
TAX RATE(40%) 20,000
EBIT 76,000

DTL= CM/(EBIT - FFC)

= 100,000/(76,000 - 8,400)
= 100,000/67,600
= 1.4793

3. Assuming that unit sales increase to 750,000 soaps, compute:

A. Degree of operating Leverage (DOL)
SALES(1.20 X 750,000) 900,000
LESS: VARIABLE COST(1.00 X 750,000) -750,000
CONTRIBUTION MARGIN 150,000
FIXED COST -50,000
OPERATING INCOME 100,000
INTEREST 6,000
TAX RATE(40%) 40,000
EBIT 146,000

DOL=CM/EBIT
= 150,000/146,000
= 1.0274

B Degree of financial leverage (DFL)

SALES(1.20 X 750,000) 900,000
LESS: VARIABLE COST(1.00 X 750,000) -750,000
CONTRIBUTION MARGIN 150,000
FIXED COST -50,000
OPERATING INCOME 100,000
INTEREST 6,000
TAX RATE(40%) 40,000
EBIT 146,000

DFL= EBIT/(EBIT-FFC)
= 146,000/(146,000 - 8,400)
= 146,000/137,600
= 1.0610

C. Degree of total leverage (DTL)

SALES(1.20 X 750,000) 900,000
LESS: VARIABLE COST(1.00 X 750,000) -750,000
CONTRIBUTION MARGIN 150,000
FIXED COST -50,000
OPERATING INCOME 100,000
INTEREST 6,000
TAX RATE(40%) 40,000
EBIT 146,000

DTL= CM/(EBIT - FFC)

= 150,000/(146,000 - 8,400)
= 150,000/137,600
= 1.0901

SOLUTION:
IN GOOD FORM