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Operating and

Financial Leverage

16-1

**© 2001 Prentice-Hall, Inc.
**

Fundamentals of Financial Management, 11/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

Operating and

Financial Leverage

Operating Leverage

Financial Leverage

Total Leverage

Cash-Flow Ability to Service Debt

Other Methods of Analysis

Combination of Methods

16-2

Operating Leverage

Operating Leverage -- The use of

fixed operating costs by the firm.

16-3

**One potential “effect” caused by the
**

presence of operating leverage is

that a change in the volume of sales

results in a “more than proportional”

change in operating profit (or loss).

18 .70 Firm V Firm 2F $11 $19.78 .82 .5 .72 .5 2 7 $ 2 14 3 $ 2.Impact of Operating Leverage on Profits (in thousands) Firm F $10 Sales Operating Costs Fixed 7 Variable 2 Operating Profit $ 1 FC/total costs FC/sales 16-4 .22 .

subject each firm to a 50% increase in sales for next year. V [ ] Firm 2F.Impact of Operating Leverage on Profits Now. 2F . EBIT)? [ ] Firm F. show the largest percentage change in operating profit.. F 16-5 [ ] Firm V.e. Which firm do you think will be more “sensitive” to the change in sales (i.

5 $29.5 $10.25 2 10.Impact of Operating Leverage on Profits (in thousands) Firm F $15 Sales Operating Costs Fixed 7 Variable 3 Operating Profit $ 5 Percentage Change in EBIT* EBIT 400% 16-6 * (EBITt .75 330% .5 $ 4 100% 14 4.EBIT t-1) / EBIT t-1 Firm V Firm 2F $16.

EBIT Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. a 50% increase in sales leads to a 400% increase in EBIT. we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage.Impact of Operating Leverage on Profits Firm F is the most “sensitive” firm -. Later.for it. 16-7 .

EBIT) and excludes debt interest and dividend payments.Break-Even Analysis Break-Even Analysis -. “profits” refers to operating profits before taxes (i.e.A technique for studying the relationship among fixed costs. profits and sales volume. .. 16-8 When studying operating leverage. profits. variable costs.

000 QUANTITY PRODUCED AND SOLD .000 7.000 6.000 2.000 5.000 3.Break-Even Chart REVENUES AND COSTS ($ thousands) Total Revenues Profits 250 Total Costs 175 Fixed Costs 100 Losses 50 0 16-9 Variable Costs 1.000 4.

FC P = Price per unit FC = Fixed costs 16-10 V = Variable costs per unit Q = Quantity (units) produced and sold .V(Q) . How to find the quantity break-even point: EBIT = P(Q) .V) .FC EBIT = Q(P .Break-Even (Quantity) Point Break-Even Point -. may be in units or in sales dollars.The sales volume required so that total revenues and total costs are equal.

V) .V) .FC = 0 16-11 QBE (P .V) .Break-Even (Quantity) Point Breakeven occurs when EBIT = 0 Q (P .FC = EBIT QBE (P .V) = FC QBE = FC / (P .

(VC / S) ] * Refer to text for derivation of the formula 16-12 .Break-Even (Sales) Point How to find the sales break-even point: SBE = FC + (VCBE) SBE = FC + (QBE )(V) or SBE * = FC / [1 .

75 each Variable costs are $18.Break-Even Point Example Basket Wonders (BW) wants to determine both the quantity and sales break-even points when: 16-13 Fixed costs are $100.75 per basket .000 Baskets are sold for $43.

000 )($18.000 SBE = $175.75 + $100.75 QBE = 4.75) $18.000 Units SBE = (QBE )(V) + FC SBE = (4.000 / ($43.$18.75 .V) QBE = $100.Break-Even Point (s) Breakeven occurs when: QBE = FC / (P .000 16-14 .75) $18.

000 7.000 6.000 3.000 5.000 2.000 4.Break-Even Chart REVENUES AND COSTS ($ thousands) Total Revenues Profits 250 Total Costs 175 Fixed Costs 100 Losses 50 0 16-15 Variable Costs 1.000 QUANTITY PRODUCED AND SOLD .

The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output (sales). DOL at Q units of = output (or sales) 16-16 Percentage change in operating profit (EBIT) Percentage change in output (or sales) .Degree of Operating Leverage (DOL) Degree of Operating Leverage -.

V ) Q (P .V) . DOLQ units = = 16-17 Q (P .Computing the DOL Calculating the DOL for a single product or a single-product firm.FC Q Q .QBE .

Computing the DOL Calculating the DOL for a multiproduct firm.FC = EBIT + FC EBIT .VC .VC S . DOLS dollars of sales 16-18 = S .

units As we did earlier.75 each Variable costs are $18.000 units. we will assume that: 16-19 Fixed costs are $100.Break-Even Point Example Lisa Miller wants to determine the degree of operating leverage at sales levels of 6.000 and 8.75 per basket .000 Baskets are sold for $43.

000 3 DOL8.000 units = 8.4.000 units = 6.000 units DOL6.000 .000 = 6.4.000 .Computing BW’s DOL Computation based on the previously calculated break-even point of 4.000 = 8.000 2 16-20 .

000 . DOL8.000 = 8.Interpretation of the DOL A 1% increase in sales above the 8.000 units = 16-21 8.000 unit level increases EBIT by 2% because of the existing operating leverage of the firm.4.000 2 .

000 .DEGREE OF OPERATING LEVERAGE (DOL) Interpretation of the DOL 5 4 3 2 1 0 -1 -2 -3 -4 -5 2.000 6.000 QBE QUANTITY PRODUCED AND SOLD 16-22 8.000 4.

the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales.Interpretation of the DOL Key Conclusions to be Drawn from Slide 16-22 and our Discussion of DOL DOL is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales. The closer that a firm operates to its break-even point. When comparing firms. the higher is the absolute value of its DOL. 16-23 .

variability DOL magnifies the variability of operating profits and. 16-24 . DOL is only one component of business risk and becomes “active” only in the presence of sales and production cost variability. Its impact is shown in the variability of the firm’s operating income (EBIT). business risk. hence.DOL and Business Risk Business Risk -.The inherent uncertainty in the physical operations of the firm.

0 .000 sales 16-25 1.000 + 7.000 = 8.Application of DOL for Our Three Firm Example Use the data in Slide 16-4 and the following formula for Firm F: DOL = [(EBIT + FC)/EBIT] DOL$10.000 = 1.

0 .000 sales 16-26 2.000 = 2.000 = 2.Application of DOL for Our Three Firm Example Use the data in Slide 16-4 and the following formula for Firm V: DOL = [(EBIT + FC)/EBIT] DOL$11.000 + 2.

6 .Application of DOL for Our Three-Firm Example Use the data in Slide 16-4 and the following formula for Firm 2F: DOL = [(EBIT + FC)/EBIT] DOL$19.500 6.500 sales 16-27 2.000 = = 2.500 + 14.

F Firm F DOL = 8.0 Firm V DOL = 6.6 Firm 2F DOL = 2.Application of DOL for Our Three-Firm Example The ranked results indicate that the firm most sensitive to the presence of operating leverage is Firm F.0 Firm F will expect a 400% increase in profit from a 50% increase in sales (see Slide 16-6 results). 16-28 .

The British expression is gearing.The use of fixed financing costs by the firm.Financial Leverage Financial Leverage -. Used as a means of increasing the return to common shareholders. 16-29 Financial leverage is acquired by choice. .

or Indifference.Pref. Analysis EBIT-EPS Break-Even Analysis -.t) . # of Common Shares . Calculate EPS for a given level of EBIT at a given financing structure.EBIT-EPS Break-Even. Div.Analysis of the effect of financing alternatives on earnings per share. EPS 16-30 = (EBIT . The break-even point is the EBIT level where EPS is the same for two (or more) alternatives.I) (1 .

S.EBIT-EPS Chart Basket Wonders has $2 million in LT financing (100% common stock equity). 16-31 Current common equity shares = 50.000 $1 million in new financing of either: All C. with a dividend rate of 9% Expected EBIT = $500.S.000 shares) All debt with a coupon rate of 10% All P.000 Income tax rate is 30% . sold at $20/share (50.

000 Preferred Dividends 0 0 EACS $350.05 16-32 * A second analysis using $150.000 EBIT rather than the expected EBIT.000 $150.000 $150. .000 # of Shares 100.000 $105.EBIT-EPS Calculation with New Equity Financing Common Stock Equity Alternative EBIT $500.000 EPS $3.000 Taxes (30% x EBT) 150.000* $150.50 $1.000 Interest 0 0 EBT $500.000 EAT $350.000 45.000 $105.000 100.

Earnings per Share ($) EBIT-EPS Chart 16-33 6 5 Common 4 3 2 1 0 0 100 200 300 400 500 EBIT ($ thousands) 600 700 .

000 $ 35.000 50.000 $ 35.000 EPS $5.000 $ 50.000 Taxes (30% x EBT) 120.000 # of Shares 50.000 EBT $400.000 EBIT rather than the expected EBIT.000 100.000* $150.70 16-34 * A second analysis using $150.60 $0.000 15.000 EAT $280.000 $150.EBIT-EPS Calculation with New Debt Financing Long-term Debt Alternative EBIT $500.000 Interest 100. .000 Preferred Dividends 0 0 EACS $280.

Earnings per Share ($) EBIT-EPS Chart 16-35 Debt 6 5 Indifference point between debt and common stock financing 4 3 Common 2 1 0 0 100 200 300 400 500 EBIT ($ thousands) 600 700 .

000 Interest 0 0 EBT $500.000 # of Shares 50.000 EBIT rather than the expected EBIT.000 EACS $260.000 EPS $5.000* $150.000 90.30 16-36 * A second analysis using $150.000 $150.000 EAT $350.20 $0. .000 $ 15.000 50.000 Taxes (30% x EBT) 150.EBIT-EPS Calculation with New Preferred Financing Preferred Stock Alternative EBIT $500.000 45.000 $105.000 Preferred Dividends 90.000 $150.

Earnings per Share ($) EBIT-EPS Chart 16-37 Debt 6 Preferred 5 Common 4 3 Indifference point between preferred stock and common stock financing 2 1 0 0 100 200 300 400 500 EBIT ($ thousands) 600 700 .

risk Only a small probability that EPS will be less if the debt alternative is chosen.6 Lower risk. 5 4 Common 3 2 1 0 0 100 200 300 400 500 600 EBIT ($ thousands) 700 Probability of Occurrence 16-38 Debt (for the probability distribution) Earnings per Share ($) What About Risk? .

Higher risk. risk A much larger probability that EPS will be less if the debt alternative is chosen. 5 4 Common 3 2 1 0 0 100 200 300 400 500 600 EBIT ($ thousands) 700 Probability of Occurrence 16-39 Debt 6 (for the probability distribution) Earnings per Share ($) What About Risk? .

16-40 Percentage change in DFL at earnings per share (EPS) EBIT of X dollars = Percentage change in operating profit (EBIT) .Degree of Financial Leverage (DFL) Degree of Financial Leverage -.The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit.

Computing the DFL Calculating the DFL DFL EBIT of $X EBIT I PD t 16-41 = EBIT EBIT .[ PD / (1 .t) ] = Earnings before interest and taxes = Interest = Preferred dividends = Corporate tax rate .I .

000 $500.000 .0)] 1.00 * The calculation is based on the expected EBIT .What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW equity* equity alternative DFL $500.[0 / (1 .000 = = 16-42 $500.0 .

000 16-43 = $500.25 * The calculation is based on the expected EBIT .000 .0)] } = $500.000 { $500.000 = 1.100.[0 / (1 .What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW debt * alternative DFL $500.000 .000 / $400.

000 / $400.000 .35 * The calculation is based on the expected EBIT .000 / (1 .30)] .0 .000 = { $500.[90.000 = 1.30 } = $500.What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW preferred * alternative DFL $500..000 16-44 $500.

Variability of EPS DFLEquity Which financing method will have DFLDebt = 1.25 the greatest relative variability in EPS? DFLPreferred = 1. . 16-45 = 1.00 This is due to the tax deductibility of interest on debt financing.35 Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL.

The added variability in earnings per share (EPS) -. For example.00 to 1.25. Debt increases the probability of cash insolvency over an all-equity-financed firm.000 to cover the interest payment. 16-46 . our example firm must have EBIT of at least $100.plus the risk of possible insolvency -. Debt also increased the variability in EPS as the DFL increased from 1.that is induced by the use of financial leverage.Financial Risk Financial Risk -.

CVEBIT.The variability in earnings per share (EPS). Total firm risk = business risk + financial risk CVEPS is a measure of relative total firm risk CVEBIT is a measure of relative business risk The difference. CVEPS . It is the sum of business plus financial risk. is a measure of relative financial risk 16-47 .Total Firm Risk Total Firm Risk -.

Degree of Total

Leverage (DTL)

Degree of Total Leverage -- The

percentage change in a firm’s earnings

per share (EPS) resulting from a 1

percent change in output (sales).

Percentage change in

DTL at Q units

(or S dollars) earnings per share (EPS)

of output (or = Percentage change in

sales)

output (or sales)

16-48

**Computing the DTL
**

DTL Q units (or S dollars) = ( DOL Q units (or S dollars) )

x ( DFL EBIT of X dollars )

DTL S dollars

of sales

DTL Q units

16-49

=

EBIT + FC

EBIT - I - [ PD / (1 - t) ]

Q (P - V )

=

Q (P - V) - FC - I - [ PD / (1 - t) ]

DTL Example

Lisa Miller wants to determine the

Degree of Total Leverage at

EBIT=$500,000. As we did earlier, we

will assume that:

Fixed

16-50

costs are $100,000

Baskets

are sold for $43.75 each

Variable

costs are $18.75 per basket

Computing the DTL for All-Equity Financing DTLS dollars = (DOL S dollars) x (DFLEBIT of $S ) DTLS dollars = (1. .20 *Note: No financial leverage.0* 1.20 DTL S dollars = of sales = 16-51 $500.000 + $100.000 $500.2 ) x ( 1..000 .0 .3 ] 1.[ 0 / (1 .0 ) = 1.3) .

000 .000 + $100.000 { $500.25* 1.25 ) = 1..50 DTL S dollars = of sales = 16-52 $500. .3) .2 ) x ( 1.[ 0 / (1 .50 *Note: Calculated on Slide 43.3 ] } 1.Computing the DTL for Debt Financing DTLS dollars = (DOL S dollars) x (DFLEBIT of $S ) DTLS dollars = (1.$100.000 .

50 $5.60 DTL 1.Risk versus Return Compare the expected EPS to the DTL for the common stock equity financing approach to the debt financing approach.50 Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)! 16-53 .20 1. Financing Equity Debt E(EPS) $3.

The greater and more stable the expected future cash flows. and preferred stock dividends.The maximum amount of debt (and other fixed-charge financing) that a firm can adequately service. lease payments. Fixed charges include: include debt principal and interest payments. . the greater the debt capacity.What is an Appropriate Amount of Financial Leverage? Debt Capacity -. 16-54 Firms must first analyze their expected future cash flows.

. 16-55 Interest Coverage EBIT Interest expenses A ratio value equal to 1 indicates that earnings are just sufficient to cover interest charges.Coverage Ratios Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest charges.

16-56 Debt-service Coverage EBIT { Interest expenses + [Principal payments / (1-t) ] } Allows us to examine the ability of the firm to meet all of its debt payments.Coverage Ratios Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest expenses and principal payments. . Failure to make principal payments is also default.

Coverage Example Make an examination of the coverage ratios for Basket Wonders when EBIT=$500.000 Principal payments of $100.000. Assume that: that Interest expenses remain at $100.000 are made yearly for 10 years 16-57 . Compare the equity and the debt financing alternatives.

50 The firm actually has greater risk than the interest coverage ratio initially suggests.00 Debt-service Coverage Infinite 2. Financing Equity Debt Interest Coverage Infinite 5. 16-58 .Coverage Example Compare the interest coverage and debt burden ratios for equity and debt financing.

PROBABILITY OF OCCURRENCE Coverage Example Firm B has a much smaller probability of failing to meet its obligations than Firm A.000 -250 16-59 Firm B 0 250 500 750 EBIT ($ thousands) 1. Firm A Debt-service burden = $200.250 .000 1.

Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt. A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.Summary of the Coverage Ratio Discussion The debt-service coverage ratio accounts for required annual principal payments. 16-60 .

and common stock equity. For example. firms are compared to peer institutions in the same industry. 16-61 .The mix (or proportion) of a firm’s permanent long-term financing represented by debt. Large deviations from norms must be justified. preferred stock.Other Methods of Analysis Capital Structure -. an industry’s median debt-to-net-worth ratio might be used as a benchmark for financial leverage comparisons. Often.

Other Methods of Analysis Surveying Investment Analysts and Lenders Firms may gain insight into the financial markets’ evaluation of their firm by talking with: 16-62 Investment bankers Institutional investors Investment analysts Lenders .

Other Methods of Analysis Security Ratings 16-63 Firms must consider the impact of any financing decision on the firm’s security rating(s). .

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