Leverage

Break Even Analysis

Relationship between Cost, Volume & Profit
At Break Even, EBIT = Zero; GP = FC
Review:
_
=
_
=

Sales/ Revenues
COGS/ COS/ Direct Cost/ Variable Cost
Operating Profit/ Gross Profit/ Contribution to
Overhead
Operating Expense/ Indirect Cost/ Overhead/ Fixed
Cost
Operating Income/ EBIT

Break Even Example

Ranbaxy Laboratory sells Ax, an asthma tablet for
Rs20/unit to distributors; cost is Re1/unit. Fixed
costs (R& D, Marketing) of the manufacturing
division are Rs200 million/year.
How many tablets it needs to sell per year to break even?

Per unit contribution:

Overhead:
Break Even Point

Selling Price
Materials
Gross Profit

Rs20
(Re1)
Rs19
Rs200,000,000

Rs200 mn / Rs19
= 10.5 mn tablets

Funskool has licensed games from independent

designers for a 50% royalty on sale price, spends
Rs50/unit on flashy packaging, and sells the games
for Rs200/each. It spends Rs15,000,000 per title on
advertising. How many copies it needs to sell to
break even?
Per unit contribution:

Overhead:
Break Even Point

Selling Price
Cost of Sales
Gross Profit
Rs15mn / Rs50 =

Rs200
(Rs150)
Rs50
Rs15,000,000
.3 million
copies

Comparing Business Models:

Unit Sales:

5 mn

25 mn

50 mn

Ranbaxy Laboratory
Sales

Rs100 mn

Rs500 mn

Rs1 billion

EBIT

(Rs105 mn)

Rs275 mn

Rs750 mn

Margin

(105%)

55%

75%

Funskool
Sales

Rs100 mn

Rs500 mn

Rs1 billion

EBIT

Rs10 mn

Rs110 mn

Rs235 mn

Margin

10%

22%

23.5%

Comparing Breakeven Points

Variable as
% Total Cost

Fixed as %
Total Cost

Breakeven
Point

Operating
Leverage

Between Industries
LAW FIRM

High

Low

Low

Low

Ranbaxy
Laboratory

Low

High

High

High

Within Industries
VINEYARD

Low

High

High

High

BOTTLER

High

Low

Low

Low

CERTAIN RELATIONSHIPS
PBIT

= Q (P V) F

PAT

= (PBIT I) ( 1 T)
(PBIT I) (1 T) Dp

EPS

=
N
= [Q (P V) F I] (1 T) Dp

OPERATING LEVERAGE
The sensitivity of profit before interest and taxes
(PBIT) to changes in unit sales is referred to as the

degree of operating leverage (DOL).

PBIT/PBIT

DOL =
Q /Q
Q (P V)

Q (P V) F

Contribution

Profit before interest and

tax

Quantifying Operating Leverage

% Change in EBIT divided by % Change in Sales
= Operating Leverage Ratio
Example:

Scenario 1

Scenario 2

% change

Sales

Rs1,000,000

Rs1,100,000

10%

COGS (20% sales)

(Rs200,000)

(Rs220,000)

10%

Rs800,000

Rs880,000

(Rs500,000)

(Rs500,000)

Fixed

Rs300,000

Rs380,000

27%

Gross Profit
Operating Expense
EBIT
Operating Leverage =

2.7 x

Financial Leverage
Financial Leverage
= amount of DEBT in Capital
Structure
Debt used to

Limit Shareholder Dilution

Reduce Cost of Capital
Increase Shareholder returns

EPS UNDER ALTERNATIVE FINANCING PLANS

Equity Financing
Interest
Profit before taxes
Taxes
Profit after tax
Number of equity
shares
Earnings per share

Debt Financing

EBIT : 2,000,000

EBIT : 4,000,000

EBIT : 2,000,000

EBIT : 4,000,000

2,000,000
1,000,000
1,000,000

4,000,000
2,000,000
2,000,000

1,400,000
600,000
300,000
300,000

1,400,000
2,600,000
1,300,000
1,300,000

2,000,000
0.50

2,000,000
1.00

1,000,000
0.30

1,000,000
1.30

BREAK-EVEN EBIT LEVEL

The EBIT indifference point between two alternative
financing plans can be obtained by solving the following

equation for EBIT*

(EBIT * I1) (1 t)

(EBIT * I2) (1 t)
=

n1

n2

ROI ROE ANALYSIS

ROE = [ROI + (ROI r) D/E] (1 t)
where ROE = return on equity
ROI = return on investment
r

= cost of debt

D/E = debt-equity ratio

= tax rate

Measuring Financial
Leverage

Financial Leverage =

% Net Income
% EBIT

When EBIT goes up or down, how

much does it affect Net Income?

FINANCIAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per
share) to changes in PBIT is referred to as the degree of financial

leverage.
PBT / PBT

DFL =

PBIT

=
PBIT / PBIT

PBIT I

Profit before interest and tax

=
Profit before tax

Financial Leverage Exercise

Example:

Scenario 1

Scenario 2

% change

EBIT

Rs2,000,000

Rs2,400,000

20%

Interest Expense

(Rs200,000)

(Rs200,000)

fixed

Pretax Income

Rs1,800,000

Rs2,200,000

22%

Taxes @40%

(Rs720,000)

(Rs880,000)

Net Income

Rs1,080,000

Rs1,320,000

Financing Leverage =

1.1x

22%

Effects of Financial Leverage

When an investor combines equity funds
with borrowed funds to leverage an
investment, the leverage increases
Expected return to the equity investor
Risk of the investment to the equity
investor

Measuring Total Leverage

Operating Leverage =

% EBIT
% Sales

Financial Leverage =

% Net Income
% EBIT

Total Leverage =

% Net Income
% Sales

Background

We know WHAT financial securities are

We know HOW to determine their cost
We know WHEN to make investments
We know HOW MUCH finance the firm
needs
We have to determine Financing Mix

How much Debt, Equity

When to choose which financing sources

Break Even Analysis

Relationship between Cost, Volume & Profit
At Break Even, EBIT = Zero; GP = FC
Review:
_
=
_
=

Sales/ Revenues
COGS/ COS/ Direct Cost/ Variable Cost
Operating Profit/ Gross Profit/ Contribution to
Overhead
Operating Expense/ Indirect Cost/ Overhead/ Fixed
Cost
Operating Income/ EBIT

Breakeven Analysis
high

Sales
COGS
Gross Profit

Rs

Year 1

Year 2

Year 3

Year 4

Breakeven Analysis
hi

Sales

Gross Profit
EBIT
Fixed Costs

Rs

Break Even Point

Year 1

Year 2

Year 3

Year 4

Break Even Example

Ranbaxy Laboratory sells Ax, an asthma tablet for
Rs20/unit to distributors; cost is Re1/unit. Fixed
costs (R& D, Marketing) of the manufacturing
division are Rs200 million/year.
How many tablets it needs to sell per year to break even?

Per unit contribution:

Overhead:
Break Even Point

Selling Price
Materials
Gross Profit

Rs20
(Re1)
Rs19
Rs200,000,000

Rs200 mn / Rs19
= 10.5 mn tablets

Funskool has licensed games from independent

designers for a 50% royalty on sale price, spends
Rs50/unit on flashy packaging, and sells the
games for Rs200/each. It spends Rs15,000,000
per title on advertising. How many copies it
needs to sell to break even?
Per unit contribution:

Overhead:
Break Even Point

Selling Price
Cost of Sales
Gross Profit
Rs15mn / Rs50 =

Rs200
(Rs150)
Rs50
Rs15,000,000
.3 million
copies

Comparing Business Models:

Unit Sales:

5 mn

25 mn

50 mn

Ranbaxy Laboratory
Sales

Rs100 mn

Rs500 mn

Rs1 billion

EBIT

(Rs105 mn)

Rs275 mn

Rs750 mn

Margin

(105%)

55%

75%

Funskool
Sales

Rs100 mn

Rs500 mn

Rs1 billion

EBIT

Rs10 mn

Rs110 mn

Rs235 mn

Margin

10%

22%

23.5%

What does Break Even tell us?

Most costs as variable costs, typically have

Low Contribution Margin per unit (e.g., law
firm)
Most costs as fixed costs, typically have High
Contribution Margin per unit (e.g., Ranbaxy
Laboratory)
Compare business strategies:

Law Firm vs Ranbaxy Laboratory

Vineyard vs Bottler

Quantify with Operating Leverage: change

in Sales vs change in Profits

Comparing Breakeven Points

Variable as
% Total Cost

Fixed as %
Total Cost

Breakeven
Point

Operating
Leverage

Between Industries
LAW FIRM

High

Low

Low

Low

Ranbaxy
Laboratory

Low

High

High

High

Within Industries
VINEYARD

Low

High

High

High

BOTTLER

High

Low

Low

Low

Quantifying Operating Leverage

% Change in EBIT divided by % Change in Sales
= Operating Leverage Ratio
Example:

Scenario 1

Scenario 2

% change

Sales

Rs1,000,000

Rs1,100,000

10%

COGS (20% sales)

(Rs200,000)

(Rs220,000)

10%

Rs800,000

Rs880,000

(Rs500,000)

(Rs500,000)

Fixed

Rs300,000

Rs380,000

27%

Gross Profit
Operating Expense
EBIT
Operating Leverage =

2.7 x

Operating Leverage Exercise

Example:

Scenario 1

Scenario 2

Sales

Rs2,000,000

Rs2,200,000

COGS (10% sales)

(Rs200,000)

(Rs220,000)

Gross Profit

Rs1,800,000

Rs1,980,000

Operating Expense
EBIT
Operating Leverage =

(Rs1,600,000) (Rs1,600,000)
Rs200,000

Rs380,000

% change

Operating Leverage Self Test

Example:

Scenario 1

Scenario 2

% change

Sales

Rs2,000,000

Rs2,200,000

10%

COGS (10% sales)

(Rs200,000)

(Rs220,000)

10%

Gross Profit

Rs1,800,000

Rs1,980,000

Operating Expense
EBIT
Operating Leverage =

(Rs1,600,000) (Rs1,600,000)
Rs200,000
9.0 x

Rs380,000

Fixed
90%

Financial Leverage
Financial Leverage
= amount of DEBT in Capital
Structure
Use Debt to:

Limit Shareholder Dilution

Reduce Cost of Capital
Increase Shareholder returns

Measuring Financial
Leverage

Financial Leverage =

% Net Income
% EBIT

When EBIT goes up or down, how

much does it affect Net Income?

Financial Leverage Exercise

Example:

Scenario 1

Scenario 2

% change

EBIT

Rs2,000,000

Rs2,400,000

20%

Interest Expense

(Rs200,000)

(Rs200,000)

fixed

Pretax Income

Rs1,800,000

Rs2,200,000

22%

Taxes @40%

(Rs720,000)

(Rs880,000)

Net Income

Rs1,080,000

Rs1,320,000

Financing Leverage =

1.1x

22%

Financial Leverage Exercise

Example:
EBIT
Interest Expense

Pretax Income
Taxes @40%
Net Income
Financing Leverage =

Scenario 1

Scenario 2

% change

Rs2,000,000

Rs2,400,000

20%

(Rs1,500,000) (Rs1,500,000)

fixed

Rs500,000

Rs900,000

(Rs200,000)

(Rs360,000)

Rs300,000

Rs540,000

4.0x

80%

80%

Financial Leverage Self Test

Example:
EBIT
Interest Expense

Pretax Income
Taxes @40%
Net Income
Financing Leverage =

Scenario 1

Scenario 2

% change

Rs2,000,000

Rs1,600,000

(20%)

(Rs1,500,000) (Rs1,500,000)

fixed

Rs500,000

Rs100,000

(Rs200,000)

(Rs40,000)

Rs300,000

Rs60,000

4.0x

(80%)

(80%)

Effects of Financial Leverage

When an investor combines equity funds
with borrowed funds to leverage an
investment, the leverage increases
Expected return to the equity investor
Risk of the investment to the equity
investor

Example of the effect on expected return

Consider a property that can be purchased for Rs100,000 today
that will increase in value by 2% during the next year and will
generate Rs8,000 during the year in cash flow for a total return
of 10%.
If an investor buys this building with Rs100,000 of equity funds,
the return on his equity investment will be 10%

10,000/100000 = .10
If an investor buys this building with Rs40,000 in equity and
Rs60,000 in debt at 8% interest, the return on his equity
investment is 13%

(10,000-4,800)/40000 = .13

Example of the effect on risk

Using debt funds increases the range, or volatility, of possible

outcomes, which we know as risk.
Consider two scenarios for the same property:

The Good: a 50% chance of being worth Rs112,000

at the end of the year and generating Rs9000 in cash
flow and
The Bad: a 50% chance of being worth Rs92,000 and
generating Rs7,000
Our expectation (mean) is that the property will be
worth Rs102,000 and generate Rs8,000 in income.
Without leverage, the range of returns to the investor is 22%
(either 21% or 1%).
With leverage (and the required interest payment, the range of
returns to the investor is 55% (either 40.5% or 14.5%)
Thus, leverage also increases risk.

Why Does Leverage Work?

Leverage is favorable if the rate of return on assets
exceeds the cost of borrowing. The difference is
called the Spread.
Favorable (positive) spread magnifies return on
equity of highly leveraged investment and vise versa.
When debt service constant is less than the rate of
return on total assets, additional financial leverage
increases cash flow to the equity position

Measuring Financial Leverage

Debt/equity ratio ratio between borrowed
funds and equity funds
Loan/value ratio ratio between borrowed
funds and market value of asset being
financed
Coverage ratio ratio between NOI and debt
service.

Measuring Financial Leverage

Greater leverage increases risk that cash flow from
investment will be insufficient to meet debt service
obligation (financial risk)
Debt coverage ratio degree to which actual net
operating income can fall below expectations and still be
sufficient to meet debt service obligation

RATIO ANALYSIS
Interest Coverage Ratio
Earnings before interest and taxes
Interest on debt

Cash Flow Coverage Ratio

EBIT + Depreciation + Other non-cash charges
Loan repayment instalment
Interest on debt

(1 Tax rate)

RATIO ANALYSIS
n
PATi + DEPi + INTi + Li
i=1
DSCR =
n
INTi + LRIi
i=1
where

DSCR
PATi
DEPi
INTi
LRIi
Li
n

Li

= debt service coverage ratio

= profit after tax for year i
= depreciation for year i
= interest on long-term loan for year i
= loan repayment instalment for year i
= lease rental for year i
= period of the loan

Is more leverage the better?

More leverage means higher risk
Higher risk for lender means higher interest rate
Higher risk for equity investor to default.
Optimal leverage is the debt ratio that maximize the
ratio between return and risk.

Measuring Total Leverage

Operating Leverage =

% EBIT
% Sales

Financial Leverage =

% Net Income
% EBIT

Total Leverage =

% Net Income
% Sales

TOTAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or
earnings per share) to changes in unit sales is referred to as
the degree of total (or combined) leverage (DTL).
PBT / PBT

DTL =

Q (P V)

=
Q /Q

Contribution
Profit before tax

DTL = DOL x DFL

PBIT T

Determining Financing Mix: Considerations

Matching Maturity of Sources and Uses

Current Assets with Current Liabilities, etc

Minimizing Cost of Financing

Maximize Stock Price

Optimal Capital Structure

Proportion of various Debt, Equity components

Capital Structure Terminology

Optimal Capital Structure
Financing Mix
Debt Capacity
Maximum Proportion of Debt to Maintain
lowest WACC

Financing Cost & Shareholder Value

The companys Investments (Assets)
generate Cash. This is ROA.
If there is only Common Stock financing,
ROA = ROE.
If there is Debt financing and Kd is less
than ROA, what happens to ROE?
Reducing cost of capital increases
Shareholder ROE and Shareholder Value