Chapter 16 Operating and Financial Leverage 16 1

Chapter 16 Operating and Financial Leverage 16. 1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

After Studying Chapter 16, you should be able to: 1. Define operating and financial leverage and identify causes of both. 2. Calculate a firm’s operating break-even (quantity) point and break-even (sales) point. 3. Define, calculate, and interpret a firm's degree of operating, financial, and total leverage. 4. Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart. 5. Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk. ” 6. Understand what is involved in determining the appropriate amount of financial leverage for a firm. 16. 2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Operating and Financial Leverage • Operating Leverage • Financial Leverage • Total Leverage • Cash-Flow Ability to Service Debt • Other Methods of Analysis • Combination of Methods 16. 3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Leverage • Capital structure refers to the mix of long term debt and equity maintained by the firm • Leverage results from the use of fixed cost assets • to magnify returns to the firm’s owners • increased leverage raises risk/return • decreased leverage lowers risk/return • Management can control leverage in the capital structure, and in turn affect firm value 16. 4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Leverage • Three types of leverage: • Operating leverage – relates sales to EBIT • Financial leverage – relates EBIT to EPS • Total leverage – relates sales to EPS • Mathematically, these three measures of leverage are related as follows: • Operating leverage × financial leverage = total leverage • sales/EBIT x EBIT/EPS = sales/EPS 16. 5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Types of leverage and income statement: 16. 6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Operating Leverage – The use of fixed operating costs by the firm. • 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). 16. 7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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. 8 0. 70 Firm V Firm 2 F $11 $19. 5 2 7 $ 2 14 3 $ 2. 5 0. 22 0. 18 0. 82 0. 72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 F; F 16. 9 [ ] Firm V; V [ ] Firm 2 F. 2 F Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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% Firm V Firm 2 F $16. 5 $29. 25 2 10. 5 $ 4 100% 14 4. 5 $10. 75 330% * (EBITt - EBIT t-1) / EBIT t-1 16. 10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Impact of Operating Leverage on Profits • • • 16. 11 Firm F 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. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Analysis – A technique for studying the relationship among fixed costs, variable costs, sales volume, and profits Also called cost/volume/profit analysis (C/V/P) analysis. • When studying operating leverage, “profits” refers to operating profits before taxes (i. e. , EBIT) and excludes debt interest and dividend payments. 16. 12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Chart REVENUES AND COSTS ($ thousands) Total Revenues Profits 250 Total Costs 175 Fixed Costs 100 Losses 50 0 Variable Costs 1, 000 2, 000 3, 000 4, 000 5, 000 6, 000 7, 000 QUANTITY PRODUCED AND SOLD 16. 13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 break-even point: EBIT = P(Q) – V(Q) – FC EBIT = Q(P – V) – FC P = Price per unit FC = Fixed costs 16. 14 V = Variable costs per unit Q = Quantity (units) produced and sold Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even (Quantity) Point • EBIT = Q(P – VC) – FC, so • Q = FC/(P – VC) = Breakeven point 16. 15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even (Quantity) Point Breakeven occurs when EBIT = 0 Q (P – V) – FC = EBIT QBE (P – V) – FC = 0 QBE (P – V) = FC QBE = FC / (P – V) a. k. a. Unit Contribution Margin 16. 16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even (Sales) Point How to find the sales break-even point: SBE = FC + (VCBE) SBE = FC + (QBE )(V) or SBE* = FC / [1 – (VC / S) ] * Refer to text for derivation of the formula 16. 17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 16. 18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Point (s) Breakeven occurs when: QBE = FC / (P – V) QBE = $100, 000 / ($43. 75 – $18. 75) $18. 75 QBE = 4, 000 Units SBE = (QBE )(V) + FC SBE = (4, 000 )($18. 75) $18. 75 + $100, 000 SBE = $175, 000 16. 19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Point • Lv Xi has fixed operating costs of $2, 500, the sale price per unit is $10, and variable operating cost per unit is $5. What is the BE point? • Q = 2, 500/(10 – 5) = 500 units • At sales of 500 units, the firm’s EBIT equals $0. The firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. • You can confirm this by substituting values above and below 500 units, along with the other values given into the equation. 16. 20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Point • Lv. Xi wishes to evaluate the impact of several options: • (1) increasing fixed operating costs to $3000, • (2) increasing the sales price per unit to $12. 50, • (3) increasing the variable operating cost per unit to $7. 50, and • (4) simultaneously implementing all three of these changes. • Substituting the appropriate data into Equation 16. 3 yields the following: 16. 21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Point • 1. OPB = 3000/(10 – 5) = 600 units • 2. OPB = 2500/(12. 50 – 5) = 333. 33 units • 3. OPB = 2500/(10 – 7. 50) = 1000 units • 4. OPB = 3000/(12. 50 – 7. 50) = 600 units • Actions 1&3 (cost increases) raise OPB • Action 2 (revenue inc. ) lowers OPB • Action 4 (combined) increases OPB 16. 22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Point • Break-even analysis: – sensitivity • increase in variable • FC effect on OPB increase • P decrease • VC increase • OPB = Operating break-even point 16. 23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Break-Even Chart REVENUES AND COSTS ($ thousands) Total Revenues Profits 250 Total Costs 175 Fixed Costs 100 Losses Variable Costs 50 0 1, 000 2, 000 3, 000 4, 000 5, 000 6, 000 7, 000 QUANTITY PRODUCED AND SOLD 16. 24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Degree of Operating Leverage (DOL) Degree of Operating Leverage – 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. 25 Percentage change in operating profit (EBIT) Percentage change in output (or sales) Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Degree of Operating Leverage (DOL) 16. 26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Degree of Operating Leverage (DOL) • Operating leverage: the potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s EBIT • an increase (decrease) in sales results in a more-than-proportionate increase (decrease) in EBIT • the ‘degree of operating leverage’ (DOL) equals: • DOL = (% change EBIT) / (% change sales) • An alternative formula (at base sales level, Q) is: • DOL = Q(P – VC)/[Q(P – VC) – FC] 16. 27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DOL Calculating the DOL for a single product or a single-product firm. DOLQ units = = 16. 28 Q (P – V) – FC Q Q – QBE Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DOL Calculating the DOL for a multiproduct firm. DOLS dollars of sales 16. 29 = S – VC – FC = EBIT + FC EBIT Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 16. 30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing BW’s DOL Computation based on the previously calculated break-even point of 4, 000 units = 6, 000 – 4, 000 3 DOL 8, 000 units = 8, 000 – 4, 000 2 DOL 6, 000 units 16. 31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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. DOL 8, 000 units = 16. 32 8, 000 = 8, 000 – 4, 000 2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 8, 000 QBE QUANTITY PRODUCED AND SOLD 16. 33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Interpretation of the DOL • Lv Xi swaps part of its variable operating costs (eliminating sales commissions) for fixed operating costs (increasing sales salaries). Result - a reduction in the variable operating cost per unit from $5 to $4. 50 and an increase in the fixed operating costs from $2, 500 to $3, 000. EBIT of $2, 500 at the 1, 000 -unit sales level is unchanged. What is Lv Xi’s DOL? • DOL = Q(P – VC)/[Q(P – VC) – FC] • = 1, 000(10 – 4. 50)/[1, 000(10 – 4. 50) – 3, 000] • = 2. 2 • Thus, the higher the firm’s fixed operating costs relative to variable operating costs, the greater the degree of operating leverage. 16. 34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Interpretation of the DOL Key Conclusions to be Drawn from the previous slide 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, 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. 16. 35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

DOL and Business Risk – The inherent uncertainty in the physical operations of the firm. Its impact is shown in the variability of the firm’s operating income (EBIT). • DOL is 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. 16. 36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Application of DOL for Our Three Firm Example Use the data in Slide 16– 8 and the following formula for Firm F : DOL = [(EBIT + FC)/EBIT] 1, 000 + 7, 000 DOL$10, 000 sales = 1, 000 16. 37 = 8. 0 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Application of DOL for Our Three Firm Example Use the data in Slide 16– 8 and the following formula for Firm V : DOL = [(EBIT + FC)/EBIT] 2, 000 + 2, 000 DOL$11, 000 sales = 2, 000 16. 38 = 2. 0 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Application of DOL for Our Three-Firm Example Use the data in Slide 16– 8 and the following formula for Firm 2 F : DOL = [(EBIT + FC)/EBIT] 2, 500 + 14, 000 = DOL$19, 500 sales = 2, 500 16. 39 6. 6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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. F Firm F DOL = 8. 0 Firm V DOL = 6. 6 Firm 2 F DOL = 2. 0 Firm F will expect a 400% increase in profit from a 50% increase in sales (see Slide 16– 10 results). 16. 40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Financial Leverage – The use of fixed financing costs by the firm. The British expression is gearing. • Financial leverage is acquired by choice. • Used as a means of increasing the return to common shareholders. 16. 41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EBIT-EPS Break-Even, or Indifference, Analysis EBIT-EPS Break-Even Analysis – Analysis of the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives. Calculate EPS for a given level of EBIT at a given financing structure. EPS 16. 42 = (EBIT – I) (1 – t) – Pref. Div. # of Common Shares Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EBIT-EPS Chart Basket Wonders has $2 million in LT financing (100% common stock equity). • Current common equity shares = 50, 000 • $1 million in new financing of either: • All C. S. sold at $20/share (50, 000 shares) • All debt with a coupon rate of 10% • All Pref. Shares with a dividend rate of 9% • Expected EBIT = $500, 000 • Income tax rate is 30% 16. 43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EBIT-EPS Calculation with New Equity Financing Common Stock Equity Alternative EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS $500, 000 0 $500, 000 150, 000 $350, 000 100, 000 $3. 50 $150, 000* $150, 000 0 $150, 000 45, 000 $105, 000 100, 000 $1. 05 * A second analysis using $150, 000 EBIT rather than the expected EBIT. 16. 44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Earnings per Share ($) EBIT-EPS Chart 6 5 Common 4 3 2 1 0 0 100 200 300 400 500 600 700 EBIT ($ thousands) 16. 45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EBIT-EPS Calculation with New Debt Financing Long-term Debt Alternative EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS $500, 000 100, 000 $400, 000 120, 000 $280, 000 50, 000 $5. 60 $150, 000* $150, 000 100, 000 $ 50, 000 15, 000 $ 35, 000 50, 000 $0. 70 * A second analysis using $150, 000 EBIT rather than the expected EBIT. 16. 46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Earnings per Share ($) EBIT-EPS Chart Debt 6 5 Indifference point between debt and common stock financing 4 3 Common 2 1 0 0 100 200 300 400 500 600 700 EBIT ($ thousands) 16. 47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

EBIT-EPS Calculation with New Preferred Financing Preferred Stock Alternative EBIT Interest EBT Taxes (30% x EBT) EAT Preferred Dividends EACS # of Shares EPS $500, 000 0 $500, 000 150, 000 $350, 000 90, 000 $260, 000 50, 000 $5. 20 $150, 000* $150, 000 0 $150, 000 45, 000 $105, 000 90, 000 $ 15, 000 50, 000 $0. 30 * A second analysis using $150, 000 EBIT rather than the expected EBIT. 16. 48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Earnings per Share ($) EBIT-EPS Chart Debt 6 Preferred 5 Common 4 3 Indifference point between preferred stock and common stock financing 2 1 0 0 100 200 300 400 500 600 700 EBIT ($ thousands) 16. 49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

6 Lower risk Only a small probability that EPS will be less if the debt alternative is chosen. 5 4 Common 3 2 1 0 0 100 200 300 400 500 600 700 Probability of Occurrence Debt (for the probability distribution) Earnings per Share ($) What About Risk? EBIT ($ thousands) 16. 50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Higher 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 Probability of Occurrence Debt 6 (for the probability distribution) Earnings per Share ($) What About Risk? 700 EBIT ($ thousands) 16. 51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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. DFL at Percentage change in EBIT of X earnings per share (EPS) dollars = Percentage change in operating profit (EBIT) 16. 52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DFL Calculating the DFL EBIT of $X EBIT I PD t 16. 53 = EBIT – I – [ PD / (1 – t) ] = Earnings before interest and taxes = Interest = Preferred dividends = Corporate tax rate Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW equity* equity alternative DFL $500, 000 = $500, 000 – 0 – [0 / (1 – 0)] = 1. 00 * The calculation is based on the expected EBIT 16. 54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW debt * alternative DFL $500, 000 = $500, 000 { $500, 000 – 100, 000 – [0 / (1 – 0)] } = $500, 000 / $400, 000 = 1. 25 * The calculation is based on the expected EBIT 16. 55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the DFL for Each of the Financing Choices? Calculating the DFL for NEW preferred * alternative DFL $500, 000 = { $500, 000 – [90, 000 / (1 – 0. 30)] 0. 30 } = $500, 000 / $371, 429 = 1. 35 * The calculation is based on the expected EBIT 16. 56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Variability of EPS DFLEquity = 1. 00 Which financing method will have DFLDebt = 1. 25 the greatest relative DFLPreferred = 1. 35 variability in EPS? • Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL. • This is due to the tax deductibility of interest on debt financing. 16. 57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Financial Risk – The added variability in earnings per share (EPS) – plus the risk of possible insolvency – that is induced by the use of financial leverage. • Debt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100, 000 to cover the interest payment. • Debt also increased the variability in EPS as the DFL increased from 1. 00 to 1. 25. 16. 58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Firm Risk – The variability in earnings per share (EPS). It is the sum of business plus financial risk. 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 – CVEBIT, is a measure of relative financial risk 16. 59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Leverage • Total leverage: the potential use of both operating and financial fixed costs to magnify the effects of changes in sales on the firm’s EPS • an increase (decrease) in sales results in a more-than-proportionate increase (decrease) in EPS • the ‘degree of total leverage’ (DTL) equals: • DTL = (% change EPS) / (% change sales), or • DTL = Q(P – VC)/[Q(P – VC) – FC – I – (Dp/(1 – t))] 16. 60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Leverage • Li Da Ltd expects annual sales of 20, 000 units at $5 per unit and incurs variable operating costs of $2 per unit, fixed operating costs of $10, 000, interest of $20, 000 and preference dividends of $12, 000. The firm is in the 40% tax bracket and has issued 5, 000 ordinary shares. The next slide presents the levels of EPS associated with the expected sales of 20, 000 units and with sales of 30, 000 units. 16. 61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Total Leverage 16. 62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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). DTL at Q units Percentage change in (or S dollars) earnings per share (EPS) = of output (or Percentage change in sales) output (or sales) 16. 63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars ) Note: the relationship is multiplicative, not additive. DTL S = dollars of sales DTL Q units 16. 64 EBIT + FC EBIT – I – [ PD / (1 – t) ] Q (P – V) = Q (P – V) – FC – I – [ PD / (1 – t) ] Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 costs are $100, 000 • Baskets are sold for $43. 75 each • Variable costs are $18. 75 per basket 16. 65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DTL for All-Equity Financing DTLS dollars = (DOL S dollars) x (DFLEBIT of $S ) DTLS dollars = (1. 2 ) x ( 1. 0* 1. 0 ) = 1. 20 DTL S dollars = of sales = $500, 000 + $100, 000 $500, 000 – [ 0 / (1 – 0. 3) 0. 3 ] 1. 20 *Note: No financial leverage. 16. 66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Computing the DTL for Debt Financing DTLS dollars = (DOL S dollars) x (DFLEBIT of $S ) DTLS dollars = (1. 2 ) x ( 1. 25* 1. 25 ) = 1. 50 DTL S dollars = of sales = $500, 000 + $100, 000 { $500, 000 – $100, 000 – [ 0 / (1 – 0. 3) 0. 3 ] } 1. 50 *Note: Calculated on Slide 16. 44. 16. 67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk versus Return Compare the expected EPS to the DTL for the common stock equity financing approach to the debt financing approach. Financing Equity Debt E(EPS) $3. 50 $5. 60 DTL 1. 20 1. 50 Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)! 16. 68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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: include debt principal and interest payments, lease payments, and preferred stock dividends. 16. 69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coverage Ratios Income Statement Ratios Coverage Ratios Indicates a firm’s ability to cover interest charges. 16. 70 Interest Coverage EBIT Interest expenses A ratio value equal to 1 indicates that earnings are just sufficient to cover interest charges. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coverage Ratios Income Statement Ratios 16. 71 Debt-service Coverage Ratios EBIT { Interest expenses + [Principal payments / (1 -t) ] } Indicates a firm’s ability to cover interest expenses and principal payments. Allows us to examine the ability of the firm to meet all of its debt payments. Failure to make principal payments is also default. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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: that • Interest expenses remain at $100, 000 • Principal payments of $100, 000 are made yearly for 10 years 16. 72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Coverage Example Compare the interest coverage and debt burden ratios for equity and debt financing. Financing Equity Debt Interest Coverage Infinite 5. 00 Debt-service Coverage Infinite 2. 50 The firm actually has greater risk than the interest coverage ratio initially suggests. 16. 73 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

PROBABILITY OF OCCURRENCE Coverage Example Firm B has a much smaller probability of failing to meet its obligations than Firm A. Firm B Firm A Debt-service burden = $200, 000 -250 0 250 500 750 1, 000 1, 250 EBIT ($ thousands) 16. 74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Summary of the Coverage Ratio Discussion 16. 75 • The debt-service coverage ratio accounts for required annual principal payments. • A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity. • 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. Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Other Methods of Analysis Capital Structure – The mix (or proportion) of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity. • Often, firms are compared to peer institutions in the same industry. • Large deviations from norms must be justified. • For example, an industry’s median debt-to-networth ratio might be used as a benchmark for financial leverage comparisons. 16. 76 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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. 77 Investment bankers Institutional investors Investment analysts Lenders Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Other Methods of Analysis Security Ratings • Firms must consider the impact of any financing decision on the firm’s security rating(s). 16. 78 Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.