Financial Management

CHAPTER 7LEVERAGE

What is Leverage?2Page #LeverageRisk is defined as the likely variability associated with expected revenue streams.The variations in the income stream can be attributed to

a.The firm's exposure to business riskb.The firm's decision to incur financial risk

Two concepts that enhance our understanding of risk...1) Operating Leverage - affects a firms business risk.

2) Financial Leverage - affects a firms financial risk.4Page #Business risk Defined as the variability of the firm's expected earnings before interest and taxes.Business risk is measured by the firm's corresponding expected coefficient of variation.Dispersion in operating income does not cause business risk. It is the result of several influences, such as the companys cost structure, product demand characteristics, and intra-industry competition.

Financial risk Is a direct result of the firm's financing decision. It refers to the additional variability in earnings available to the firms common stockholders and the additional chance of insolvency borne by the common shareholder when financial leverage is used.Financial leverage is the financing of a portion of the firm's assets with securities bearing a fixed rate of return in hopes of increasing the return to the common shareholders.

Business RiskThe variability or uncertainty of a firms operating income (EBIT).FIRMEBITEPSStock-holders7Page #Business RiskAffected by:Sales volume variabilityCompetitionProduct diversificationOperating leverageGrowth prospectsSize8Page #Operating LeverageThe 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.9Page #

EBITOperatingLeverage10Page #Financial RiskThe variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.11Page #Financial RiskThe variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.FIRMEBITEPSStock-holders12Page #Financial RiskThe variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.FIRMEBITEPSStock-holders13Page #Financial LeverageThe use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).14Page #

EPSFinancialLeverage15Page #Breakeven AnalysisIllustrates the effects of operating leverage.Useful for forecasting the profitability of a firm, division, or product line.Useful for analyzing the impact of changes in fixed costs, variable costs, and sales price.1612Page #CostsSuppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).17Page #Quantity{$Total RevenueTotal CostFC18Page #Quantity{$Total RevenueTotal CostFCQ1+-}EBIT19Page #Quantity{$Total RevenueTotal CostFCBreak-evenpointQ1+-}EBIT20Page #Operating LeverageWhat happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?21Page #Quantity{$Total RevenueTotal Cost= FixedFCBreak-evenpoint}Q1+-EBIT22Page #

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.23Page #Quantity{$Total RevenueTotal Cost= FixedFCBreak-evenpoint}Q1+-EBITTrade-off: the firm hasa higher breakeven point. If sales are not high enough, the firm will not meet its fixedexpenses!24Page #Breakeven CalculationsBreakeven point (units of output)QB = FP - V25Page #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 CalculationsQB = FP - V26Page #Breakeven CalculationsS* = F VC S1 -Breakeven point (sales dollars)27Page #Breakeven point (sales dollars)

S* = breakeven level of sales.F = total anticipated fixed costs.S = total sales.VC = total variable costs.Breakeven CalculationsS* = F VC S1 -28Page #Analytical Income Statement sales- variable costs- fixed costs operating income- interest EBT- taxes net income29Page #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.30Page #DOLs = % change in EBIT% change in salesDegree of Operating Leveragefrom Sales Level (S)31Page #DOLs = % change in EBIT% change in saleschange in EBIT EBITchange in sales sales=Degree of Operating Leveragefrom Sales Level (S)32Page #DOLs = Sales - Variable Costs EBITIf we have the data, we can use this formula:Degree of Operating Leveragefrom Sales Level (S)33Page #If we have the data, we can use this formula:Degree of Operating Leveragefrom Sales Level (S) Q(P - V) Q(P - V) - F=DOLs = Sales - Variable Costs EBIT34Page #What does this tell us?If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).35Page #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-holdersEBITEPSSales36Page #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.37Page #DFL = % change in EPS% change in EBITDegree of Financial Leverage 38Page #DFL = % change in EPS% change in EBITchange in EPS EPSchange in EBIT EBITDegree of Financial Leverage =39Page #Degree of Financial Leverage DFL = EBIT EBIT - IIf we have the data, we can use this formula:40Page #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.41Page #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-holdersEBITEPSSales42Page #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.43Page #DCL = DOL x DFL Degree of Combined Leverage 44Page #DCL = DOL x DFL Degree of Combined Leverage % change in EPS% change in Sales=45Page #DCL = DOL x DFL Degree of Combined Leverage =% change in EPS% change in Saleschange in EPS EPSchange in Sales Sales=46Page #DCL = Sales - Variable Costs EBIT - IIf we have the data, we can use this formula:Degree of Combined Leverage 47Page #Degree of Combined Leverage If we have the data, we can use this formula:DCL = Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I=48Page #What does this tell us?If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.49Page #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-holdersEBITEPSSales50Page #In-class Project:Based on the following information on Levered Company, answer these questions:

1) If sales increase by 10%, what should happen to operating income?2) If operating income increases by 10%, what should happen to EPS?3) If sales increase by 10%, what should be the effect on EPS?51Page #Levered CompanySales (100,000 units)$1,400,000Variable Costs $800,000Fixed Costs $250,000Interest paid $125,000Tax rate 34%Common shares outstanding 100,000

52Page #

EPSFinancialleverage

OperatingIncomeSalesOperatingleverageLevered Company53Page #Degree of Operating Leverage from Sales Level (S)DOLs = Sales - Variable Costs EBIT54Page #Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000

=DOLs = Sales - Variable Costs EBIT55Page #Degree of Operating Leverage from Sales Level (S) 1,400,000 - 800,000 350,000

= 1.714=DOLs = Sales - Variable Costs EBIT56Page #

EPSOperatingIncomeSalesLevered Company57Page #

EPSOperatingIncomeSalesOperatingleverageLevered Company58Page #

EPSOperatingIncomeSalesOperatingleverage10%Levered Company59Page #

EPSOperatingIncomeSalesOperatingleverage10%17.14%Levered Company60Page #Degree of Financial Leverage DFL = EBIT EBIT - I61Page #Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000

62Page #Degree of Financial Leverage DFL = EBIT EBIT - I = 350,000 225,000

= 1.55663Page #

EPSOperatingIncomeSalesLevered Company64Page #

EPSFinancialleverageOperatingIncomeSales10%Levered Company65Page #

EPSFinancialleverageOperatingIncomeSales10%15.56%Levered Company66Page #

EPSFinancialleverageOperatingIncomeSales10%15.56%

Levered Company67Page #Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I68Page #Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000

=69Page #Degree of Combined Leverage DCL = Sales - Variable Costs EBIT - I 1,400,000 - 800,000 225,000

= 2.667=70Page #

EPSOperatingIncomeSalesLevered Company71Page #

EPSOperatingIncomeSalesOperatingleverageLevered Company72Page #

EPSFinancialleverageOperatingIncomeSalesOperatingleverageLevered Company73Page #

EPSFinancialleverageOperatingIncomeSalesOperatingleverage10%26.67%Levered Company74Page #

EPSFinancialleverage

OperatingIncomeSales10%26.67%OperatingleverageLevered Company75Page # Sales (110,000 units)1,540,000 Variable Costs (880,000) Fixed Costs (250,000) EBIT 410,000 ( +17.14%) Interest (125,000) EBT 285,000 Taxes (34%) (96,900) Net Income 188,100 EPS $1.881 ( +26.67%)Levered Company10% increase in sales76Page #Summary FORMULA:

Break-even/ BE = FC/P-VCDOL = Q(P-VC)/Q(P-VC)-FCDFL = EBIT/EBIT INTERESTDCL = Q(P-VC)/Q(P-VC)-FC-INTERESTQuantity/ Q = PROFIT OR NET INCOME/P-VCPrice = TR/UNIT SOLD77Page #ExercisePERSIAN PLATE COMPANYINCOME STATEMENTFOR THE YEAR ENDED DECEMBER 31, 2014

Sales (40,000 plates at $20 each) $800,000 Less: Variable costs (40,000 plates at $10 400,000 Fixed costs 150,000 Earnings before interest and taxes (EBIT) 250,000 Less: Sales Interest expense 30,000 Earnings before taxes (EBT) 220,000 Income tax expense (30%) . 66,000 Earnings after taxes (EAT) . $154,000Given this income statement, compute the following:

Degree of operating leverageDegree of financial leverageDegree of combined leverageBreak-even point in units

ANSWER:

DOL = Q(P-VC) / Q(P-VC)-FC = 40,000($20-$10) / 40,000 ($20-$10) 150,000 = 400,000 / 400,000-150,000 = 400,000 / 250,000 = 1.6 Times

DFL = EBIT / EBIT INTEREST = 250,000 / 250,000 30,000 = 250,000 / 220,000 = 1.14 Times

DCL = Q(P-VC) / Q(P-VC FC INTEREST = 40,000 ($20-$10) / 40,000 ($20-$10) 150,000 30,000

= 400,000 / 400,000 150,000 30,000 = 400,000 / 220,000 = 1.81 Times

BEBE = FC / D-VC = 150,000 / $20-$10 = 150,000 / 10 = 15,000 Units