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Topic3 Financial and Operating Leveraging-Edited-231111_084005
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Transcript of Topic3 Financial and Operating Leveraging-Edited-231111_084005
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Topic 3Financial and OperatingLeveraging
Business vs. financial risk
Operating leverage Financial Leverage
Degree of Financial & Operating Leverage
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Uncertainty about future operating income (EBIT),i.e., how well can we predict operating income?
Note that business risk does not include financingeffects.
What is business risk?
Probability
EBITE(EBIT)0
Low risk
High risk
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What determines business risk? Uncertainty about demand (sales).
Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Operating leverage.
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What is operating leverage, and how
does it affect a firms business risk? Operating leverage is the use of fixed costs
rather than variable costs.
If most costs are fixed, hence do not decline
when demand falls, then the firm has highoperating leverage.
A business that makes few sales, with each saleproviding a very high gross margin, is said to behighly leveraged. A business that makes manysales, with each sale contributing a very slightmargin, is said to be less leveraged.
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Effect of operating leverage More operating leverage leads to more business risk,
for then a small sales decline causes a big profitdecline.
For example, convenience stores are significantly less
leveraged than high-end car dealerships
Sales
$ Rev.TC
FC
QBE Sales
$ Rev.
TC
FC
QBE
} Profit
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Using operating leverage
Typical situation: Can use operating leverageto get higher E(EBIT), but risk also increases.
Probability
EBITL
Low operating leverage
High operating leverage
EBITH
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What is financial leverage?
Financial risk? Financial leverage is the use of debt
and preferred stock.
Financial risk is the additional riskconcentrated on commonstockholders as a result of financialleverage.
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Business risk vs. Financial risk Business risk depends on business
factors such as competition, product
liability, and operating leverage. Financial risk depends only on the
types of securities issued. More debt, more financial risk.
Concentrates business risk onstockholders.
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An example:
Illustrating effects of financial leverage Two firms with the same operating leverage,
business risk, and probability distribution ofEBIT.
Only differ with respect to their use of debt(capital structure).
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
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Firm U: UnleveragedEconomy
Bad Avg. Good
Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400
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Firm L: LeveragedEconomy
Bad Avg. GoodProb.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680
*Same as for Firm U.
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Ratio comparison between
leveraged and unleveraged firmsFIRM U Bad Avg GoodBEP* 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%
TIE
FIRM L Bad Avg GoodBEP* 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.50x 3.30x
*BEP (Basic earning power)
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Risk and return for leveraged
and unleveraged firmsExpected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%E(ROE) 9.0% 10.8%E(TIE) 2.5x
Risk Measures:Firm U Firm L
ROE 2.12% 4.24%
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The effect of leverage on
profitability and debt coverage For leverage to raise expected ROE, must
have BEP > kd.
Why? If kd > BEP, then the interest expensewill be higher than the operating incomeproduced by debt-financed assets, soleverage will depress income.
As debt increases, TIE decreases becauseEBIT is unaffected by debt, and interestexpense increases (Int Exp = kdD).
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Conclusions Basic earning power (BEP) is
unaffected by financial leverage.
L has higher expected ROE becauseBEP > kd.
L has much wider ROE (and EPS)swings because of fixed interest
charges. Its higher expected returnis accompanied by higher risk.
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Breakeven Analysis
Breakeven Analysis is used to:
determine the level of operations necessary to
cover all operating costs, and
evaluate the profitability associated with variouslevels of sales.
The firms operating breakeven point (OBP) is the level
of sales necessary to cover all operating expenses.
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Breakeven Analysis To calculate the OBP, cost of goods sold and operating
expenses must be categorized as fixed or variable.
Variable costs vary directly with the level of sales and
are a function of volume, not time.
Fixed costs are a function of time and do not vary with
sales volume.
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Algebraic Approach
P = sales price per unit
Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit
EBIT = (P x Q) - FC - (VC x Q) Letting EBIT = 0 and solving for Q, we get:
Breakeven Analysis
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Using the following variables, the operating portion of
a firms income statement may be recast as follows:
Algebraic/Equation Approach
P = sales price per unit
Q = sales quantity in units
FC = fixed operating costs per period
VC = variable operating costs per unit
Q = FC
P - VC
Breakeven Analysis
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Algebraic Approach
Breakeven Analysis
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Example: Omnibus Posters has fixed operating costs
of $2,500, a sales price of $10/poster, and variable
costs of $5/poster. Find the OBP.
Algebraic Approach
Q = $2,500 = 500 posters
$10 - $5
Breakeven Analysis
$ = 500 X $10 = $5000
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We can check to verify that this is the case by
substituting as follows:
Algebraic Approach
EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($10 x 500) - $2,500 - ($5 x 500)
EBIT = $5,000 - $2,500 - $2,500 =$0
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Breakeven Analysis
The contribution margin method is a variationof the equation method.
Fixed expensesUnit contribution margin=Break-even pointin units sold
Fixed expenses
CM ratio
=Break-even point in
total sales dollars
Contribution Margin Approach
$ = $2,500 = $50000.5
Q = $2,500 = 500 posters$10 - $5
Fixed expenses(Sales-VC)/Sales
=
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Graphic Approach
Quantity Total Total Total Total
Sold Revenue Costs FC VC EBIT
- - 2,500 2,500 - (2,500)
500 5,000 7,500 2,500 2,500 -
1,000 10,000 12,500 2,500 5,000 2,500
1,500 15,000 17,500 2,500 7,500 5,000
2,000 20,000 22,500 2,500 10,000 7,500
2,500 25,000 27,500 2,500 12,500 10,000
3,000 30,000 15,000 2,500 15,000 12,500
EBIT at Various Levels of Quantit Sold
Breakeven Analysis
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-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
- 500 1,000 1,500 2,000
sales (posters)
revenue/costs
($)
Total Revenue Total Costs Total FC
Breakeven Analysis
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Target Profit Analysis
We can use our Cost Volume profit (CVP)
formula to determine the sales volumeneeded to achieve a target net profitfigure.
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CVP Equation Method
Q = $2,500 + $500 = 600 posters
$10 - $5
$ = 600 X $10 = $6000
LET SAY YOUR TARGET PROFIT IS $500
Target Profit Analysis
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Target Profit Analysis
The contribution margin method is a variationof the equation method.
Fixed expensesUnit contribution margin=Unit sales to attainthe target profit
Fixed expenses
CM ratio
=total sales dollars toAttain the target profit
Contribution Margin Approach
$ = $2,500 + 500 = $60000.5
Q = $2,500 + 500 = 600 posters$10 - $5
Fixed expenses(Sales-VC)/Sales
=
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Margin of safety (MOS) is the excessof budgeted or actual sales over the
breakeven volume of sales. It state theamount by which sales can drop beforelosses begin to be incurred. The higher
the margin of safety, the lower the riskof not breaking even.
Margin of Safety (MOS)
http://www.accountingformanagement.com/break_even_point_definition.htmhttp://www.accountingformanagement.com/break_even_point_definition.htm -
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Margin of Safety (MOS)
MOS = Total Actual Sales BE sales
Let say; BE = $5000, Sales = $5500
Therefore MOS = 5500 5000= 500
If in %, MOS(%) = 500/5000
= 0.1 or 10%Therefore if reduction in sales of $500 or 10%,the result will be just break even.
O i & Fi i l L
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Operating & Financial Leverage
O ti & Fi i l L
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Scenario 1 Scenario 2 Scenario 3
10% Sales Sales Rem ain 10% Sales
Decrease Unchanged Increase
Net Sales 630,000$ 700,000$ 770,000$
Less: Variable Costs
(60% of Sales) 378,000 420,000 462,000
Less: Fixed Costs 200,000 200,000 200,000
EBIT 52,000 80,000 108,000Less: Interest Expens 20,000 20,000 20,000
EBT 32,000 60,000 88,000
Less: Taxes (30%) 9,600 18,000 26,400
Net Income 22,400$ 42,000$ 61,600$
Effects of Leverage on the Income Statement
Operating & Financial Leverage
O ti & Fi i l L
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Degree of Operating Leverage
The degree of operating leverage (DOL) measures the
sensitivity of changes in EBIT to changes in Sales.
A companys DOL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DOL.
Operating & Financial Leverage
O ti & Fi i l L
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Operating & Financial Leverage
Degree of Operating Leverage
Scenario 1 Scenario 2 Scenario 3Sales Decrease Sales Rem ain Sales Increase
10.0% Unchanged 10.0%
Net Sales 630,000$ 700,000$ 770,000$
Les s: Variable Costs
(60% of Sales ) 378,000 420,000 462,000
Les s: Fixed Costs 200,000 200,000 200,000
EBIT 52,000 80,000 108,000
Ebit Decreases Ebit Increases
(52-80)/80 35.0% (108-80)/80 35.0%
Effects of Operating Leverage on the Income Statement
O ti & Fi i l L
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Interval Estimate of DOL
DOL = % Change in EBIT = 35% = 3.50 x
% Change in Sales 10%
Operating & Financial Leverage
Degree of Operating Leverage
O ti & Fi i l L
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Point Estimate of DOL
DOL = Sales - VC = 700 - 420 = 3.50 xSales - VC - FC 700 - 420 - 200
Operating & Financial Leverage
Degree of Operating Leverage
DOL = CM
EBIT
O ti & Fi i l L
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Degree of Financial Leverage
The degree of financial leverage (DFL) measures the
sensitivity of changes in EPS to changes in EBIT.
Only companies that use debt or other forms of fixed
cost financing (debt or PS) will experience financial
leverage.
Operating & Financial Leverage
O ti & Fi i l L
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Degree of Financial Leverage
Operating & Financial Leverage
Scenario 1 Scenario 2 Scenario 3
EBIT Dcrease Sales Remain EBIT Increase
35.00% Unchanged 35.00%
EBIT 52,000 80,000 108,000
Less: Interest Expens 20,000 20,000 20,000
EBT 32,000 60,000 88,000
Less: Taxes (30%) 9,600 18,000 26,400
Net Income 22,400$ 42,000$ 61,600$
EPS (42,000 shares) 0.533$ 1.00$ 1.467$
EPS Decreases EPS Increases
46.67% 46.67%
Effects of Financial Leverage on the Income Statement
O ti & Fi i l L
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Interval Estimate ofDFL
DFL = % Change in EPS = 46.67% = 1.33
% Change in EBIT 35.00%
Operating & Financial Leverage
Degree of Financial Leverage
Operating & Financial Leverage
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Point Estimate of DFL
DFL = EBIT = 80 = 1.33EBIT - Interest 80 - 20
DFL = EBIT = 108 = 1.23EBIT - Interest 108 - 20
Operating & Financial Leverage
Degree of Financial Leverage
Ope ating & Financial Le e age
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Operating & Financial Leverage
Scenario 1 Scenario 2 Scenario 3
10% Sales Sales Remain 10% Sales
Decrease Unchanged Increase
Net Sales 630,000$ 700,000$ 770,000$Less: Variable Costs
(60% of Sales) 378,000 420,000 462,000
Less: Fixed Costs 200,000 200,000 200,000
EBIT 52,000 80,000 108,000
Less: Interest Expens 20,000 20,000 20,000EBT 32,000 60,000 88,000
Less: Taxes (30%) 9,600 18,000 26,400
Net Income 22,400$ 42,000$ 61,600$
EPS (42,000 shares) 0.53$ 1.00$ 1.47$
EPS Decreases EPS Increases46.67% 46.67%
Effects of Combined Leverage on the Income Statement
Degree of Total Leverage
Operating & Financial Leverage
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Interval Estimate ofDTL
DTL = % Change in EPS = 46.7% = 4.67
% Change in Sales 10%
Operating & Financial Leverage
Degree of Total Leverage
Operating & Financial Leverage
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Point Estimate of DTL
DTL = Q x (P - VC)
Q x (P-VC) - FC - I
Operating & Financial Leverage
Degree of Total Leverage
DTL = 700 - 420 = 4.67
700 - 420 - 200 - 20
Operating & Financial Leverage
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DTL = DOL x DFL
Operating & Financial Leverage
Degree of Total Leverage
DTL = 3.50 x 1.33 = 4.6
Applying this to our example at a sales level of $77, we get: