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Lecture 10

Operating
Operating and
and Financial
Financial
Leverage
Leverage and
and its
its effect
effect
on
on earnings
earnings

Operating and
Financial Leverage

Operating Leverage
Financial Leverage
Total Leverage
Cash-Flow Ability to Service Debt
Other Methods of Analysis
Combination of Methods

Operating Leverage
Operating Leverage -- The use of fixed
operating costs by the firm.
A measurement of the degree to which a
firm or a project uses a combination of
fixed and variable costs.
It is the percentage of fixed costs within
a company's operating structure & is
used to evaluate a potential break even
point for operating costs or determining
what you need to sell in order to cover
what you've already spent.
In addition, it can also be used to

Operating Leverage
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).
There are two types of operating
leverages based on the quantity of
fixed cost in business.
1.High operating leverage
2.Low operating leverage

Operating Leverage
High operating leverageis when a
company has a large amount of monthly
fixed costs.
Each month, Company A has a number
of fixed costs, including rent, factory
space,
and
production
materials.
Company A must earn a large profit on
each sale in order to cover the funds
already spent. The higher the number of
fixed costs, means the higher operating
leverage, means greater risk.

Operating Leverage
Low operating leverageis when a
company has a low amount of monthly
fixed costs.
Each month, Company B only incurs costs
if there is a sale of their product. For
example, Company B sells special hand
made wooden chairs. These chairs are
only produced when an order is placed.
Since all chairs are made to order,
Company B doesn't need to have as a
high of a sales volume as Company A in

Impact of Operating
Leverage on Profits
(in thousands)
Firm

1
Firm 2
$11
$19.5

Firm 3

Sales
$10
Operating Costs
Fixed
7
2
14
Variable
2
7
3
Operating Profit $ 1 $ 2
$ 2.5
FC/total costs
FC/sales

.78 .22
.70 .18

.82
.72

Impact of Operating
Leverage on Profits
Now, subject each firm to a 50%
increase in sales for next year.
Which firm do you think will be more
sensitive to the change in sales
(i.e., show the largest percentage
change in operating profit, EBIT)?
[ ] Firm 1;
[ ] Firm 2; [ ] Firm 3.

Impact of Operating
Leverage on Profits
Firm
1
Firm
(in
thousands)

2
$16.5

Firm 3
$29.25

Sales
$15
Operating Costs
Fixed
7 2
14
Variable
3 10.5 4.5
Operating Profit $ 5
$ 4
$10.75
Percentage
Change in EBIT* 400%
100%
330%

* (EBITt - EBIT

) / EBIT

t-1

t-1

Impact of Operating
Leverage on Profits
Firm 1 is the most sensitive firm -for it, a 50% increase in sales leads to
a 400% increase in 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.

Break-Even Analysis
Break-Even Analysis -- A technique for
studying the relationship among fixed
costs, variable costs, profits, and sales
volume.

The break-even analysis lets you determine


what you need to sell, monthly or annually,
to cover your costs of doing businessyour
break-even point.
When studying operating leverage, profits
refers to operating profits before taxes (i.e.,
EBIT) and excludes debt interest and dividend
payments.

Break-Even
(Quantity) Point
Break-Even Point -- The sales volume required
so that total revenues and total costs are
equal; may be in units or in sales dollars.

How to find the quantity breakeven point:


EBIT = P(Q) - V(Q) - FC
EBIT = Q(P - V) - FC
P = Price per unit
per unit

V = Variable costs

Break-Even
(Quantity) Point
Breakeven occurs when EBIT
= 0 a.k.a. Unit Contribution
Q (P - V) - FC = EBITMargin
QBE (P - V) - FC = 0
QBE (P - V) = FC
QBE = FC / (P - V)

Break-Even (Sales)
Point
How to find the sales break-even
point:
SBE = FC + (VCBE)
SBE

= FC + (QBE )(V)

or
*
* Refer to text
derivation
formula
S
= for
FC
/ [1 of-the(VC
/ S) ]
BE

Break-Even
Point Example
Basket Wonders (BW) wants to
determine both the quantity and
sales break-even points when:

Fixed costs are $100,000


Baskets are sold for $43.75 each
Variable costs are $18.75 per
basket

Break-Even Point
(s)
Breakeven occurs when:
QBE = FC / (P - V)
QBE = $100,000 / ($43.75 - $18.75)
QBE = 4,000 Units
SBE = (QBE )(V) + FC
SBE = (4,000 )($18.75) + $100,000
SBE = $175,000

Break-Even Chart
REVENUES AND COSTS
($ thousands)

Total Revenues
Profits

250

Total Costs

175

100

Fixed Costs
Losses

Variable Costs

50
0
1,000
2,000
3,000
4,000
6,000
7,000
QUANTITY PRODUCED AND SOLD

5,000

Degree of Operating
Leverage (DOL)
Degree of Operating Leverage -- The
percentage change in a firms operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
DOL at Q
units of
output
(or sales)

Percentage change in
operating profit (EBIT)
Percentage change in
output (or sales)

Degree of Operating Leverage


(DOL)

A type ofleverage ratioexplaining the


effect, a particular amount ofoperating
leverage,has on a company'soperating
income.
Operating leverage involves using a
large
proportion
offixed
coststovariable costsin the operations
of the firm.
The higher the degree of operating
leverage, the more volatile
theEBITfigure will be relative to a
given change in sales, all other things

Computing the DOL


Calculating the DOL for a single
product or a single-product firm.

DOLQ units

=
=

Q (P - V)
Q (P - V) - FC
Q
Q - QBE

Computing the DOL


Calculating the DOL for a
multiproduct firm.

DOLS dollars of sales

S - VC
S - VC - FC
EBIT + FC
EBIT

Break-Even
Point Example
Lisa Miller wants to determine the
degree of operating leverage at sales
levels of 6,000 and 8,000 units. As we
did earlier, we will assume that:

Fixed costs are $100,000


Baskets are sold for $43.75 each
Variable costs are $18.75 per basket

Computing BWs
DOL
Computation based on the previously
calculated break-even point of 4,000
units
6,000
DOL6,000 units =
= 3
6,000 - 4,000
DOL8,000 units

8,000
2
=
= 8,000 - 4,000

Interpretation of the
DOL
A 1% increase in sales above the
8,000 unit level increases EBIT by 2%
because of the existing operating
leverage of the firm.
DOL8,000 units

8,000
2
=
= 8,000 - 4,000

DEGREE OF OPERATING
LEVERAGE (DOL)

Interpretation of the
DOL
5
4
3
2
1
0
-1
-2
-3
-4
-5

2,000

4,000

6,000

QBE
QUANTITY PRODUCED AND SOLD

8,000

Interpretation of the
DOL

DOL is a quantitative measure of the


sensitivity of a firms operating
profit to a change in the firms sales.
The closer that a firm operates to its
break-even point, the higher is the
absolute value of its DOL.
When comparing firms, the firm with
the highest DOL is the firm that will
be most sensitive to a change in
sales.

DOL and Business


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

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 sales

1,000 + 7,000
= 8.0
=
1,000

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 sales

2,000 + 2,000
= 2.0
=
2,000

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 sales

2,500 + 14,000
= 6.6
=
2,500

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.
Firm F
DOL = 8.0
Firm V
DOL = 6.6
Firm 2F DOL = 2.0
Firm F will expect a 400% increase in profit from a
50% increase in sales (see Slide 16-6 results).

Financial Leverage
Financial Leverage -- The use of fixed
financing costs by the firm. The British
is gearing.
expression
Financial leverage
is the degree to which a
company uses fixed-income securities such as
debt and preferred equity.
The more debt financing a company uses, the
higher its financial leverage.
A high degree of financial leverage means
high interest payments, which negatively
affect the company's bottom-line earnings per
share.
Financial leverage is acquired by choice. Used

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

Computing the DFL


Calculating the DFL
DFL EBIT of $X

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

EBIT
= Earnings before interest and taxes
I
= Interest
PD
= Preferred dividends
t
= Corporate tax rate

Degree of Financial
Leverage
(DFL)
With Newco's
current production,
its sales are
$7 million annually. The company's variable
costs of sales are 40% of sales, and its fixed
costs are $2.4 million. The company's annual
interest expense is $100,000. If we increase
Newco's EBIT by 20%, how much will the
company's EPS increase?
Calculation and Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/
($7,000,000-$2,800,000-$2,400,000$100,000)
DFL = $1,800,000/$1,700,000 = 1.058

What is an Appropriate
Amount of Financial Leverage?
Debt Capacity -- The maximum amount of debt
(and other fixed-charge financing) that a firm
can adequately service.

Firms must first analyze their expected


future cash flows.
The greater and more stable the
expected future cash flows, the greater
the debt capacity.
Fixed charges include: debt principal
and interest payments, lease

Coverage Ratios
Income Statement
Ratios
Coverage Ratios

Indicates a firms
ability to cover
interest charges.

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 firms
ability to cover
interest expenses
and principal
payments.

Debt-service
Coverage
EBIT
{ Interest expenses +
[Principal payments / (1Allows us tot)examine
the
]}

ability of the firm to meet


all of its debt 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. Compare the
equity and the debt financing
alternatives.
Assume that:
Interest

expenses remain at
$100,000
Principal payments of $100,000 are
made yearly for 10 years

Coverage Example
Compare the interest coverage and debt
burden ratios for equity and debt
financing.
Interest
Debt-service
Financing
Coverage
Coverage
Equity
Infinite
Infinite
Debt
5.00
2.50