Chapter Operating and

5 Financial Leverage

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• What is leverage?
• Break-even analysis
• Operating leverage
• Financial leverage
• Combined leverage
• Potential profits or increased risk?

5-2
 What is Leverage?
• Use of special forces and effects to magnify
or produce more than normal results from a
given course of action
– Can produce beneficial results in favorable
conditions
– Can produce highly negative results in
unfavorable conditions

5-3
 Leverage in a Business
• Determining type of fixed operational costs
– Plant and equipment
• Eliminates labor in production of inventory
– Expensive labor
• Lessens opportunity for profit but reduces risk
exposure
• Determining type of fixed financial costs
– Debt financing
• Substantial profits but failure to meet contractual
obligations can result in bankruptcy
– Selling equity
• Reduces potential profits but minimizes risk exposure
5-4
 Operating Leverage
• Extent to which fixed assets and associated
fixed costs are utilized in a business
• Operational costs include:
– Fixed
– Variable
– Semivariable

5-5
Break-Even Chart: Leveraged Firm

5-6
 Break-Even Analysis
• The break-even point is at 50,000 units,
where the total costs and total revenue
lines intersect
Units = 50,000
.

Total Variable Fixed Costs Total Costs Total Revenue Operating

Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0

5-7
 Break-Even Analysis (cont’d)
• The break-even point can also be
calculated by:

Fixed costs = Fixed costs = FC

Contribution margin Price – Variable cost per unit P – VC

i.e. $60,000 = $60,000 = 50,000 units

$2.00 - $0.80 $1.20

5-8
 Volume-Cost-Profit Analysis:
Leveraged Firm
Table 5-2

5-9
 A Conservative Approach
• Some firms choose not to operate at high
degrees of operating leverage
– More expensive variable costs may be
substituted for automated plant and equipment
– This approach may cut into potential profitability
of the firm

5-10
Break-Even Chart:
Conservative Firm

5-11
 Volume-Cost-Profit Analysis:
Conservative Firm
Table 5-3

5-12
 The Risk Factor
• Factors influencing decision on maintaining
a conservative or leveraged position
include:
– Economic condition
– Competitive position within industry
– Future position – stability versus market
leadership
– Matching an acceptable return with a desired
level of risk

5-13
 Cash Break-Even Analysis
• Deals with cash flows rather than
accounting flows
• Helps in analyzing the short-term outlook of
a firm
• Examples of noncash items that are
excluded:
– Depreciation
– Credit sales
– Credit purchase of materials
5-14
 Degree of Operating Leverage
(DOL)
• Percentage change in operating income as
a result of a percentage change in units
sold
• Computed only over a profitable range of
operations
• More when it is computed closer to BEP
DOL = Percent change in operating income
Percent change in unit volume

5-15
Operating Income or Loss

5-16
 Computation of DOL
• Leveraged firm:

DOL = Percent change in operating income = $24,000 X 100

Percent change in unit volume $36,000

20,000 X 100
80,000
= 67% = 2.7
25%
• Conservative firm:

DOL = Percent change in operating income = $8,000 X 100

Percent change in unit volume $20,000

20,000 X 100
80,000
= 40% = 1.6
25%
5-17
 Algebraic Formula for DOL
DOL = Q (P – VC) ,
Q (P – VC) – FC
Where,
• Q = Quantity at which DOL is computed
• P = Price per unit
• VC = Variable costs per unit
• FC = Fixed costs
• For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80,
and FC = $60,000:

DOL = 80,000 ($2.00 - $0.80) ;

80,000 ($2.00 - $0.80) - $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) - $60,000 $96,000 - $60,000
DOL = 2.7
5-18
 Limitations of Analysis
• Assumption of existence of constant or
linear function for revenues and costs as
volume changes
– May not hold good in real world
• Price weakening to capture increasing market
• Cost overruns when moved beyond optimum-size
operation
– Relationships are not so fixed as assumed

5-19
 Nonlinear Break-Even Analysis
• Assumption of exact linear relation does not hold good in
reality

5-20
 Financial Leverage
• Reflects the amount of debt used in the
capital structure of the firm
• Determines how the operation is to be
financed
• Determines the performance between two
firms having equal operating capabilities
BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

5-21
 Impact on Earnings
• Examine two financial plans for a firm,
where $200,000 is required to carry the
assets

Total Assets = $200,000

Plan A (leveraged) Plan B (conservative)

Debt (8% interest) $150,000 ($12,000 interest) $ 50,000 ($4,000 interest)
Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at
$6.25)

Total financing $200,000 $200,000

5-22
 Impact of Financing Plan on
Earnings per Share
Table 5-5

5-23
Financing Plans and Earnings
per Share

5-24
 Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT

• For the purpose of computation, it can be restated as:

DFL = EBIT .
EBIT – I
• DFL for two plans can be calculated using values from Table 5-5
– Plan A (Leveraged):
DFL = EBIT = $36,000 = $36,000 = 1.5
EBIT – I $36,000 - $12,000 $24,000

– Plan B (Conservative):
DFL = EBIT = $36,000 = $36,000 = 1.1
EBIT – I $36,000 - $4,000 $32,000

5-25
 Limitations to Use
of Financial Leverage
• Beyond a point, debt financing is
detrimental to the firm
– Lenders will perceive a greater financial risk
– Common stockholders may drive down the
price
• Recommended for firms that are:
– In an industry that is generally stable
– In a positive stage of growth
– Operating in favorable economic conditions
5-26
 Combining Operating
and Financial Leverage
• Combined leverage: when both leverages
allow a firm to maximize returns
– Operating leverage:
• Affects the asset structure of the firm
• Determines the return from operations
– Financial leverage:
• Affects the debt-equity mix
• Determines how the benefits received will be
allocated

5-27
 Combined Leverage Influence
on the Income Statement

• Last item under operating leverage, operating income, becomes the

initial item for determining financial leverage
• “Operating income” and “Earnings before interest and taxes” are one
and the same, representing the return to the owners before interest
and taxes are paid
5-28
 Combining Operating
and Financial Leverage

5-29
 Operating and Financial
Leverage
Table 5-7

5-30
 Degree of Combined Leverage
• Uses the entire income statement
• Shows the impact of a change in sales or
volume on bottom-line earnings per share
DCL = Percentage change in EPS ;
Percentage change in sales (or volume)

• Using data from Table 5-7:

Percent change in EPS $1.50 X 100

$1.50 = 100% = 4
Percent change in sales $40,000 X 100 25%
= $160,000

5-31
 Degree of Combined Leverage
(cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
• Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable
costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I
(Interest) = $12,000.

DCL = 80,000 ($2.00 – $0.80) =

80,000 ($2.00 - $0.80) – $60,000 – $12,000
= 80,000 ($1.20) =
80,000 ($1.20) – $72,000
DCL = $96,000 = $96,000 = 4
$96,000 – $72,000 $24,000
5-32