Chapter 5 Operating and Financial Leverage Copyright 2011

Chapter 5 Operating and Financial Leverage Copyright © 2011 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw-Hill/Irwin

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 Income Costs (TVC) (FC) (50, 000 X $0. 80) $40, 000 $60, 000 Total Costs Total Revenue (TC) (TR) (50, 000 X $2) $100, 000 Operating (loss) 0 5 -7

Break-Even Analysis (cont’d) • The break-even point can also be calculated by: Fixed costs = Contribution margin i. e. Fixed costs = Price – Variable cost per unit FC P – VC $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 = Percent change in unit volume = • $24, 000 X 100 $36, 000 20, 000 X 100 80, 000 67% = 2. 7 25% Conservative firm: DOL = Percent change in operating income = Percent change in unit volume = $8, 000 X 100 $20, 000 X 100 80, 000 40% = 1. 6 25% 5 -17

Algebraic Formula for 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 Operating leverage Liabilities and Net Worth 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) Debt (8% interest) $150, 000 ($12, 000 interest) Common stock 50, 000 (8000 shares at $6. 25) Plan B (conservative) $ 50, 000 ($4, 000 interest) 150, 000 (24, 000 shares at $6. 25) Total financing $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 – I • DFL for two plans can be calculated using values from Table 5 -5 – Plan A (Leveraged): DFL = EBIT = $36, 000 = 1. 5 EBIT – I $36, 000 - $12, 000 $24, 000 – Plan B (Conservative): DFL = EBIT = $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) – $72, 000 DCL = $96, 000 = 4 $96, 000 – $72, 000 $24, 000 5 -32