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Chapter

9
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Foundations of Financial Management

Operating and Financial Leverage

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The McGraw-Hill Companies, Inc. 2000

9 Chapter 5 - Outline
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What is Leverage? Operating Leverage Financial Leverage Leverage Means Risk Combined or Total Leverage
Block Hirt Irwin/McGraw-Hill
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What is Leverage?
Leverage is using fixed costs to magnify the potential return to a firm

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2 types of fixed costs: fixed operating costs = rent, depreciation fixed financial costs = interest costs from debt
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Operating Leverage
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 firms operating income to a in sales

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9
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th EDITION Figure 5-1Break-even chart: Leveraged firmPage 114 Total


Revenues and costs ($ thousands) 200 Profit 160 120 100 80 60 40 BE Variable costs Loss Fixed costs Total costs

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T 5-1

Revenue

20
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40 50 60

80

100

120
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Units produced and sold (thousands) Fixed costs ($60,000) Price ($2) Variable costs per unit ($0.80)

9 We use Equation 5-1 to calculate the break-even (BE)


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pointPage 115

BE

Fixed costs Fixed costs FC 5 - 1 Contributi on margin Price - Variable cost per unit P - VC

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

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Table 5-2 Volume-cost-profit analysis: Leveraged firmPage 115


Units Sold
Total Variable Costs

Fixed Costs
$ 60,000 60,000 60,000 60,000 60,000 60,000 60,000

Total Costs
$ 60,000 76,000 92,000 100,000 108,000 124,000 140,000

Total Revenue
0 $ 40,000 80,000 100,000 120,000 160,000 200,000

Operating Income (loss) $ (60,000) (36,000) (12,000) 0 12,000 36,000 60,000

0 0 20,000 $16,000 40,000 32,000 50,000 40,000 60,000 48,000 80,000 64,000 100,000 80,000

Block Hirt Irwin/McGraw-Hill

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T 5-3

Figure 5-2 Break-even chart: Conservative firmPage 116


Revenues and costs ($ thousands) 200 160 120 80 40 Loss BE Variable costs Profit Total costs

Total Revenue

20

40

60

80

100

Fixed costs 120

Units produced and sold (thousands) Block Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60) Hirt Irwin/McGraw-Hill The McGraw-Hill Companies, Inc. 2000

9
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th EDITION Table 5-3 Volume-cost-profit analysis: Conservative firmPage 117


Units Sold

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T 5-4

Total Variable Costs 0 $ 32,000 48,000 64,000 96,000 128,000 160,000

Fixed Costs $ 12,000 12,000 12,000 12,000 12,000 12,000 12,000

Total Costs

Operating Total Income Revenue (loss) 0 $ 40,000 60,000 80,000 120,000 160,000 200,000
$ (12,000) (4,000) 0 4,000 12,000 20,000 28,000
. .

0 20,000 30,000 40,000 60,000 80,000 100,000

$12,000 44,000 60,000 76,000 108,000 140,000 172,000

Block Hirt Irwin/McGraw-Hill

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Equation 5-3 gives another method of computing DOL

Q(P - VC) 5 - 3 DOL Q(P - VC) - FC

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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Table 5-4 Operating income or lossPage 118


Units 0 20,000 40,000 60,000 80,000 100,000 . . . . . . . . . . . . . . . . . . Leveraged Firm (Table 5-2) $(60,000) (36,000) (12,000) 12,000 36,000 60,000 Conservative Firm (Table 5-3) $(12,000) (4,000) 4,000 12,000 20,000 28,000

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9
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th EDITION Figure 5-3 Nonlinear break-even analysisPage Revenue 120


Revenues and costs ($ thousands) 200 160 120 Total revenue weakness

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T 5-6

Cost overruns

80
40

Total costs

Valid area

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20

40

60 80 Units (thousands)

100

120

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Financial Leverage
Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

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Financial Leverage is a measure of the amount of debt used by a firm


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

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Foundations of Financial Management

Degree of Financial Leverage (DFL) = %age in EPS / %age in EBIT (or OI)
Block Hirt Irwin/McGraw-Hill
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A in EBIT (or OI) a larger in EPS


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9
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th EDITION Table 5-5Impact of financing plan on earnings per sharePage 122 Plan A Plan B
(leveraged) 1. EBIT (0) Earnings before interest and taxes (EBIT) 0 Interest (I) $(12,000) Earnings before taxes (EBT) (12,000) Taxes (T) * (6,000) Earnings after taxes (EAT) $ (6,000) Shares 8,000 Earnings per share (EPS) $ (0.75) 2. EBIT ($12,000) Earnings before interest and taxes (EBIT) $12,000 Interest (I) 12,000 Earnings before taxes (EBT) 0 Taxes (T) 0 Earnings after taxes (EAT) $ 0 Shares 8,000 Earnings per share (EPS) 0
. . . .

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(conservative) 0

$ (4,000) (4,000) (2,000) $ (2,000) 24,000 $ (0.08)


. . . .

$12,000 4,000 8,000 4,000 $ 4,000 24,000 $0.17

* The assumption is that large losses can be written off against other income, perhaps in other years, thus Block providing the firm with a tax savings benefit. The tax rate is 50 percent for ease of computation. Hirt Irwin/McGraw-Hill The McGraw-Hill Companies, Inc. 2000

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Table 5-5 (continued)--Impact of financing plan on earnings per sharePage 122


Plan A (leveraged) 3. EBIT ($16,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings after taxes (EAT) Shares Earnings per share (EPS) 4. EBIT ($36,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings after taxes (EAT) Shares Earnings per share (EPS) $ 16,000 12,000 4,000 2,000 $ 2,000 8,000 $0.25 $ 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50 Plan B (conservative) $ 16,000 4,000 12,000 6,000 $ 6,000 24,000 $0.25 $ 36,000 4,000 32,000 16,000 $ 16,000 24,000 $0.67

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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T 5-7

Table 5-5 (continued)Impact of financing plan on earnings per sharePage 122


Plan A (leveraged) 5. EBIT ($60,000) Earnings before interest and taxes (EBIT) Interest (I) Earnings before taxes (EBT) Taxes (T) Earnings after taxes (EAT) Shares Earnings per share (EPS) $ 60,000 12,000 48,000 24,000 $ 24,000 8,000 $3.00 Plan B (conservative) $ 60,000 4,000 56,000 28,000 $ 28,000 24,000 $ 1.17

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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T 5-8 th EDITION Figure 5-4 Financing plans and earnings per sharePage 121 EPS ($)
4 Plan A 3 2 Plan B

Foundations of Financial Management

1
.25 0 -1 -2
Block Hirt Irwin/McGraw-Hill

12

16

25

50 75 EBIT (thousands)

100
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Financial Leverage Break-Even point


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Block Hirt Irwin/McGraw-Hill

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In the previous figure (5-4), the point where Plans A and B cross is a financial break-even point.
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

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Financial breakeven occurs when EBIT = borrowing rate X total assets


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9 If EBIT is to be
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below this BE point, we would prefer Plan B, with a conservative, low level of debt.
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

If EBIT is to be above this BE point, we would prefer Plan A, with an aggressive, high level of debt.
The McGraw-Hill Companies, Inc. 2000

Block Hirt Irwin/McGraw-Hill

9
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Foundations of Financial Management

One way to measure the relative level of debt is to compute the Degree of Financial Leverage (Equations 5-4 and 5-5).
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

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Degree of Financial Leverage (Equations 5-4 and 5-5)


Percent change in EPS EBIT DFL Percent change in EBIT EBIT - I

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

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About DOL and DFL


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

Note that DOL is never less than 1.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

A DOL of 1 means there is no fixed cost in the firm.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

Note that DFL is never less than 1.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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th

Foundations of Financial Management

A DFL of 1 means there is no debt in the firm.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

Degree of combined leverage = DCL = DOL X DFL.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

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Foundations of Financial Management

Block Hirt Irwin/McGraw-Hill

DCL is never less than 1.


The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

DCL = 1 means the firm has no fixed costs and no debt.


Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000

9
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Foundations of Financial Management

If a firm has inherent business risk, then it should use debt and fixed costs sparingly to reduce overall risk.
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Block Hirt Irwin/McGraw-Hill

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Leverage Means Risk


Leverage is a double-edged sword It magnifies profits as well as losses An aggressive or highly leveraged firm has a relatively high break-even point (and high fixed costs) A conservative or non-leveraged firm has a relatively low break-even point (and low fixed costs)

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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T 5-9

Table 5-6 Income statementPage 124


Sales (total revenue) (80,000 units @ $2) Fixed costs Variable costs ($0.80 per unit) Operating income Earnings before interest and taxes Interest Earnings before taxes Taxes Earnings after taxes Shares Earnings per share $160,000 60,000 64,000 $ 36,000 $ 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50
Operating leverage

Financial leverage

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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T 5-10 th EDITION Figure 5-5 Combining operating and financial leverage Page 125

Foundations of Financial Management

$ Earnings generated

EPS = $1.50

Operating income = EBIT $36,000 $36,000

Financial leverage

Operating leverage Sales = $160,000

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Leverage impact
The McGraw-Hill Companies, Inc. 2000

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Combined or Total Leverage


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

Block Hirt Irwin/McGraw-Hill

The McGraw-Hill Companies, Inc. 2000

9
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T 5-11

Table 5-7 --Operating and financial leverage Page 126 (80,000 units) (100,000 units)
Sales $2 per unit Fixed costs Variable costs ($0.80 per unit) Operating income (EBIT) Interest Earnings before taxes Taxes Earnings after taxes Shares Earnings per share $160,000 60,000 64,000 36,000 12,000 24,000 12,000 $ 12,000 8,000 $1.50 $200,000 60,000 80,000 60,000 12,000 48,000 24,000 $ 24,000 8,000 $3.00

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Note than unit sales increased by 25%; EBIT increased by 67% (operating leverage); and EPS increased by 100% (financial leverage).
The McGraw-Hill Companies, Inc. 2000

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THE END
Block Hirt Irwin/McGraw-Hill
The McGraw-Hill Companies, Inc. 2000