1

• Operating Leverage

• Financial Leverage

2

Business Risk

• The variability or uncertainty of a firm’s operating income (EBIT).

FIRMFIRMEBIT EPSStock-Stock-holdersholders

3

Business Risk

Affected by:

• Sales volume variability

• Competition

• Cost variability

• Product diversification

• Product demand

• Operating Leverage

4

Operating Leverage

• The use of fixed operating costs as opposed to variable operating costs.

• A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

5

Financial Risk

• The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

FIRMFIRMEBIT EPSStock-Stock-holdersholders

6

Financial Leverage

• The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

• A firm with relatively high fixed financing costs will experience more net income if EBIT changes.

7

Costs

• Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

8

Operating Leverage

• What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

9

With high operating leverage, an increase in sales

produces a relatively larger increase in operating

income.

10

Trade-off: Trade-off: the firm hasthe firm has

a higher breakeven a higher breakeven point. If sales are not point. If sales are not high enough, the firm high enough, the firm will not meet its fixedwill not meet its fixed

expenses!expenses!

11

Breakeven point (units of output)

• QB = breakeven level of Q.

• F = total anticipated fixed costs.

• P = sales price per unit.

• V = variable cost per unit.

Breakeven Calculations

QB = FP - V

12

Breakeven point (sales dollars)

• S* = breakeven level of sales.

• F = total anticipated fixed costs.

• S = total sales.

• VC = total variable costs.

Breakeven Calculations

S* = F VC S

1 -

13

Degree of Operating Leverage (DOL)

• Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income.

• This “multiplier effect” is called the degree of operating leverage.

14

DOLs = % change in EBIT% change in sales

=

Degree of Operating Leveragefrom Sales Level (S)

Sales - Variable Costs EBIT

Q(P - V) Q(P - V) - F=

15

What does this tell us?

• If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).

Stock-holdersEBIT EPSSales

16

Degree of Financial Leverage (DFL)

• Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share.

• This “multiplier effect” is called the degree of financial leverage.

17

DFL = % change in EPS% change in EBIT

EBIT EBIT - I

Degree of Financial Leverage

=

18

What does this tell us?

• If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.

Stock-holdersEBIT EPSSales

19

Degree of Combined Leverage (DCL)

• Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share.

• This “multiplier effect” is called the degree of combined leverage.

20

DCL = DOL x DFL

Degree of Combined Leverage

=% change in EPS% change in Sales

Sales - Variable Costs EBIT - I

=

=

Q(P - V) Q(P - V) - F - I

21

What does this tell us?

• If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.

Stock-holdersEBIT EPSSales

22

In-class Project:

• Based on the following information on Levered Company, answer these questions:

1) If sales increase by 1%, what should happen to operating income?

2) If operating income increases by 1%, what should happen to EPS?

3) If sales increase by 1%, what should be the effect on EPS?

23

Levered Company

Sales (100,000 units) $1,400,000

Variable Costs $800,000

Fixed Costs $250,000

Interest paid $125,000

Tax rate 34%

Common shares outstanding 100,000

24

Sales

EBITEPS

DOL

DFL

DCL

Leverage

25

Degree of Operating Leverage from Sales Level (S)

1,400,000 - 800,000 350,000

= 1.714

=

DOLs = Sales - Variable Costs EBIT

26

Levered Company

Sales

EBITEPS

DOL = 1.714

DFL =

DCL

27

Degree of Financial Leverage

DFL = EBIT EBIT - I

= 350,000 225,000

= 1.556

28

Levered Company

Sales

EBITEPS

DOL = 1.714

DFL = 1.556

DCL

29

Degree of Combined Leverage

DCL = Sales - Variable Costs EBIT - I

1,400,000 - 800,000 225,000

= 2.667

=

30

Levered Company

Sales

EBITEPS

DOL = 1.714

DFL = 1.556

DCL= 2.667

31

Sales (110,000 units) 1,414,000

Variable Costs (808,000)

Fixed Costs (250,000)

EBIT 356,000 ( +1.714%)

Interest (125,000)

EBT 231,000

Taxes (34%) (78,540)

Net Income 152,460

EPS $1.5246 ( +2.667%)

Levered Company1% increase in sales