Analysis and Impact of Leverages Dr Pawan Gupta

What is Leverage?

2 more concepts that enhance our understanding of risk... 1) Operati ng Leverage aff ects a fir m’ s busi ness ri sk. -

2) Fi nanci al Lev erage aff ects a fir m’ s financi al ri sk.

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) .

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) . EBIT

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) . EBIT FIRM

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) . EBIT FIRM EPS

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) . EBIT FIRM EPS Stockholders

Business Risk
• The vari ability or uncer tainty of a firm’ s oper ating income (E BIT) . EBIT FIRM EPS Stockholders

Business Risk
Affe cted by: • Sales vo lume var iability , • Compet ition, • Cos t v ariability , • Product diver sification, • Product demand

Operating Leverage
• The use of f ixed oper ating cost s as oppose d t o var iable oper ating cost s. • A f irm with r elative ly high fixed operatin g cost s w ill experience mor e v ariable oper ating income if

EBIT
Operating Leverage

Financial Risk
• The varia bility or uncer tainty of a firm’ s ear ni ngs per s hare (E PS ) and t he incr eased probabilit y of insolv ency that ar ises w hen a f ir m us es fi nancia l lev erage.

Financial Risk
• The varia bility or uncer tainty of a firm’ s ear ni ngs per s hare (E PS ) and t he incr eased probabilit y of insolv ency that ar ises w hen a f ir m us es fi nancia l StockFIRM EPS E lev erage. holders BIT

Financial Risk
• The var iability o r uncer tainty of a firm’ s ear nings per share (E PS) and t he incr eased probabi li ty of insolv ency t hat ar ises when a f ir m us es financial lev erage. StockFIRM EPS EBIT holders

Financial Leverage
• The use of f ixed-cos t sour ces of f inanci ng (debt, preferr ed st ock) ra ther t han varia ble-cos t sour ces (common st ock) .

EPS
Financial Leverage

Breakeven Analysis
$

Quantity

Total Revenue

$

Quantity

Costs
• Suppose the firm h as both fixed opera ting cost s (administ rativ e salar ies, ins urance, re nt, pr operty tax) and var iable operat ing cost s (materia ls, labor, ener gy, packaging, sales

Total Revenue

$

Total Cost

FC { Quantity

Total Revenue

$

+

}EBIT

Total Cost

FC {
Breakeven point

Q1

Quantity

Operati ng Leverage
• What h appens if t he f irm increas es it s fixed oper ating cost s and re duces ( or eliminates ) its var iable costs ?

Total Revenue

$

+
FC

{

}
Q1

EBIT
Total Cost = Fixed Quantity

Breakeven point

With high oper ating lev erage , an increase in sales pr oduces a relativel y larger incr ease in oper ating income .

Total Revenue Trade-off:

$

FC

{

Breakeven point

the firm has a higher breakeven EBIT point. If sales are not + enough, the firm high will not meet its fixed Total Cost expenses! = Fixed

}

Q1

Quantity

Breakeven Calculations
Breakeven point of output ) ( unit s

F QB = P-V

Breakeven Calculations
Breakeven point of output ) ( unit s

F QB = P-V

• Q B = breakev en level of Q. • F = total a nticipated fixed cost s.

Breakeven Calculations
Br eakeven point dollars ) F ( sales

S* =

VC 1S

Breakeven Calculations
Br eakeven point dollars ) F ( sales

S* =

VC 1S

• S* = breakeve n l evel of sales . • F = total ant icipated fixed cost s.

Analytical Income Statement
Sales var iable costs f ix ed costs oper ating income inter est EBT taxes Net Income

Analytical Income Statement
Sales contribution margin var iable costs f ix ed costs oper ating income inter est EBT taxes Net Income

}

Analytical Income Statement
Sales var iable costs f ix ed costs oper ating income inter est EBT (1 - t) = Net Income, EBT so, taxes Net Income / (1 - t) = EBT Net Income

Degree of Operating Leverage (DOL)
• Oper ating leve rage: by us ing f ixed oper ating cost s, a s mall change in sa les rev enue is magnified into a la rger change in oper ating income . This “multi plier eff ect ” is called t he degree of

Degree of Operating Leverage from Sales Level (S)
DOLs = % change in EBIT % change in sales

Degree of Operating Leverage from Sales Level (S)
DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales

=

Degree of Operating Leverage from Sales Level (S)
• If w e have the dat a, we can use this formula: Sales - Variable Costs DOLs = EBIT

Degree of Operating Leverage from Sales Level (S)
• If w e have the dat a, we can use this formula: Sales - Variable Costs DOLs = EBIT = Q(P - V) Q(P - V) - F

What does this tell us?
• If DOL = 2 , then a 1% increase in sale s will resul t in a 2% increase in op erati ng income (EBI T).

What does this tell us?
• If DOL = 2 , then a 1% increase in sale s wi ll resul t in a 2% increase in ope rati ng income (EBI T).
Sales EBIT EPS

Stockholders

Degree of Financial Leverage (DFL)
• Financial leve rage: by usi ng f ixed cost f inancin g, a s mall change in oper ating income is magnified into a lar ger change in earn ings per shar e. Th is “multiplier ef fect” is

Degree of Financial Leverage
DFL = % change in EPS % change in EBIT

Degree of Financial Leverage
DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT

=

Degree of Financial Leverage
• If w e have the dat a, we can use this formula: EBIT DFL = EBIT - I

What does this tell us?
• If DFL = 3, then a 1% increase in op erati ng income will r esul t in a 3% increase in earni ngs per share.

What does this tell us?
• If DFL = 3, then a 1% increase in op erati ng income will r esul t in a 3% increase in earni ngs per share.
Sales EBIT EPS

Stockholders

Degree of Combined Leverage (DCL)
• Combined lever age: b y using oper ating lev erage and financial lever age , a small change in sales is magnified int o a larger c hange in ear nings per share . • This “mult iplier eff ect ” is called t he degree of

Degree of Combined Leverage
DCL = DOL x DFL % change in EPS = % change in Sales change in EPS EPS change in Sales Sales

=

Degree of Combined Leverage
• If w e have the dat a, we can use this formula: Sales - Variable Costs DCL = EBIT - I

Degree of Combined Leverage
• If w e have the dat a, we can use this formula: Sales - Variable Costs DCL = EBIT - I = Q(P - V) Q(P - V) - F - I

Leverage Sales
DCL DOL

EPS

DFL

EBIT

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