18961198-designing-managing-marketing-channel.ppt

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© 2003 McGraw-Hill Ryerson Limited

5 C h

a p t e r

Operating and Financial

Leverage

McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited

Prepared by:

Terry FegartySeneca College

Revised By

P Chua




Chapter 5 - Outline

What is Leverage?

Break-even Analysis

Operating LeverageFinancial Leverage

Combined or Total Leverage

Summary and Conclusions

PPT 5-2




What is Leverage?

In general terms, leverage means the use of force and effects toproduce a more than normal results from a given action

In other words, leverage is the advantage generated by using alever

Example, using a jack to lift a car

In Finance, leverage is the use of fixed costs to magnify thepotential return to a firm

2 types of fixed costs:

fixed operating costs = rent, salaries, etc.

fixed financial costs = interest costs from debt

PPT 5-3




What is Leverage?

Leverage can magnify returns to common stockholders but can alsoincrease risk

Management has almost complete control over this risk introducedthrough the use of leverage (fixed costs)

The degree in the use of leverage depends on management’s attitudetoward risk and the nature of its business, among others.

Three types of leverage with reference to the firm’s income statement:

Operating leverage,

Financial leverage, and

Combined (Total) leverage.

Leverage is measured on the profitability range of operations.




What is Leverage?

Sales

Less: Cost of Goods Sold

Gross Margin

Less: Operating ExpensesEarnings Before Interest and Taxes (EBIT)

Less: Interest

Earnings Before Taxes

Less: Taxes

Earnings After Taxes (EAT)

Number of Shares Outstanding

Earnings Per Share

Operating

leverage

Financial

leverage




What is Leverage?

Sales

Less: Total variable Costs

Contribution Margin

Less: Fixed CostEarnings Before Interest and Taxes (EBIT)

Less: Interest

Earnings Before Taxes

Less: Taxes

Earnings After Taxes (EAT)

Number of Shares Outstanding

Earnings Per Share

Operating

leverage

Financial

leverage


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Breakeven Analysis

Break-even Analysis is used by the firm:

To determine the level of operations necessary to cover all operatingcosts, and

To evaluate the profitability associated with various levels of sales.

The Operating Breakeven Point is the level of sales necessary to cover alloperating costs.

The formula for determining operating breakeven is:

EBIT = (P Q ) – (VC Q ) – FC (1)

where

P = sales price per unitQ = sales quantity in units

FC = fixed operating cost per period

VC = variable operating cost per unit

EBIT = earnings before interest and taxes



Breakeven Quantity

Equation (1) can be rewritten to solve for the sales

quantity that will breakeven:

(2)

Since P – VC is the Contribution Margin per unit

(CM/unit), equation 2 becomes:

(3)

VC P

FC

Q

unit CM

FC Q

/



Breakeven Analysis

Plan A (Leveraged) Plan B (Less Leveraged-

Conservative)

Selling Price (/unit) = $2.00

Fixed Cost = $60,000 Fixed Cost = $12,000

Variable Cost (/unit) = $0.80 Variable Cost (/unit) = $1.60

Contribution Margin(/unit) = $1.20 Contribution Margin(/unit) = $0.40

Break-Even Point (units) = 50,000 Break-Even Point (units) = 30,000



PPT 5-4

Figure 5-1

Break-even chart: leveraged firm

Revenues and costs ($ thousands)

20 40 50 60 80 100 120

Total

Revenue

Totalcosts

Variable costs

Fixedcosts

Profit

BE

Loss

Units produced and sold (thousands)

200

160

120

100

80

60

40

Price ($2)

Variable costs per unit ($0.80)Fixed costs ($60,000)



Table 5-2

Volume-cost-profit analysis: Leveragedfirm

Total Operating

Units Variable Fixed Total Total Income

Sold Costs Costs Costs Revenue (loss)

0 0 $60,000 $ 60,000 0 $(60,000)

20,000 16,000 60,000 76,000 $ 40,000 (36,000)

40,000 32,000 60,000 92,000 80,000 (12,000)

50,000 40,000 60,000 100,000 100,000 0

60,000 48,000 60,000 108,000 120,000 12,000

80,000 64,000 60,000 124,000 160,000 36,000

100,000 80,000 60,000 140,000 200,000 60,000

PPT 5-5



PPT 5-6

Figure 5-2

Break-even chart: conservative firm

Revenues and costs ($ thousands)

200

160

120

80

40

20 40 60 80 100 120

Total

Revenue

Totalcosts

Variable costs

Fixedcosts

Profit

BE

Loss

Units produced and sold (thousands)

Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)



Table 5-3

Volume-cost-profit analysis: LessLeveraged (Conservative) firm

0 0 $12,000 $ 12,000 0 $(12,000.

)20,000 $ 32,000 12,000 44,000 $ 40,000 (4,000.)

30,000 48,000 12,000 60,000 60,000 0

40,000 64,000 12,000 76,000 80,000 4,000

60,000 96,000 12,000 108,000 120,000 12,000

80,000 128,000 12,000 140,000 160,000 20,000

100,000 160,000 12,000 172,000 200,000 28,000

Total Operating

Units Variable Fixed Total Total Income

Sold Costs Costs Costs Revenue (loss)

PPT 5-7



0 $(60,000) $(12,000)

20,000 (36,000) (4,000)

30,000 (12,000) 0

40,000 (12,000) 4,000

50,000 0 8,00060,000 12,000 12,000

80,000 36,000 20,000

100,000 60,000 28,000

Leveraged Less LeveragedPlan (Conservative)

PlanUnits EBIT EBIT

PPT 5-10

Table 5-4

Operating income or loss



Leverage Means Risk

Leverage is a double-edged sword

It magnifies losses as well as profits

An aggressive or highly leveraged firm has a

relatively high break-even point (and high fixed

costs)

A conservative or less-leveraged firm has a

relatively low break-even point (and low fixed costs)

PPT 5-8



Operating Leverage

Measures the amount of fixed operating costs used

by a firm

Operating Leverage measures the sensitivity of a

firm’s operating income to a in sales a in Sales a larger in EBIT (or OI)

Degree of Operating Leverage (DOL)=%age in EBIT ( or OI)

%age in Sales

PPT 5-9



Calculating the Degree of OperatingLeverage

DOL can be computed using the following formula:

or

or

FC VC P Q

VC P Q

)(

)( DOL

FC TVC S

TVC S

DOL

EBIT

CM DOL



Financial Leverage

Measure of the amount of debt used

and interest paid by a firm

Financial Leverage measures the sensitivity of a

firm’s earnings per share to a in operating income a in EBIT (or OI) a larger in EPS

Degree of Financial Leverage (DFL) =%age in EPS

%age in EBIT (or OI)

PPT 5-12



Calculating the Degree of FinancialLeverage

DFL can be computed using the following formula:

I EBIT EBIT

DFL




Financing Plans

Total Assets = $200,000

Plan A (Leveraged) Plan B (Less

Leveraged-Conservative)

Debt (8%) $150,000 ($12,000

interest)

$50,000 ($4,000 interest)

Common Stock $50,000 (8,000 shares @

$6.25)

$150,000 (24,000 shares

@ $6.25)

Total Financing $200,000 $200,000




1. EBIT (0)

Earnings before interest and taxes (EBIT) 0 0 — Interest (I) $(12,000.) $ (4,000.)Earnings before taxes (EBT) (12,000.) (4,000.) — Taxes (T) * (6,000.) (2,000.)

Earnings aftertaxes(EAT) $ (6,000.) $ (2,000.)Shares 8,000 24,000Earnings per share (EPS) $ (0.75) $ (0.08)

2. EBIT ($12,000)

Earnings before interest and taxes (EBIT) $12,000 $12,000 — Interest (I) 12,000 4,000Earnings before taxes (EBT) 0 8,000 — Taxes (T) 0 4,000Earnings aftertaxes (EAT) $ 0 $ 4,000Shares 8,000 24,000Earnings per share (EPS) 0 $0.17

Plan A Plan B (leveraged) (conservative)

* The assumption is that large losses can be written off against other income, perhaps in other years, thusproviding the firm with a tax savings benefit. The tax rate is 50 percent.

PPT 5-13 Table 5-5a Impact of financing plan on earnings pershare




3. EBIT ($16,000)

Earnings before interest and taxes (EBIT) $ 16,000 $ 16,000

— Interest (I) 12,000 4,000

Earnings before taxes (EBT) 4,000 12,000

— Taxes (T) 2,000 6,000Earnings aftertaxes (EAT) $ 2,000 $ 6,000

Shares 8,000 24,000

Earnings per share (EPS) $0.25 $0.25

4. EBIT ($36,000)

Earnings before interest and taxes (EBIT) $ 36,000 $ 36,000 — Interest (I) 12,000 4,000

Earnings before taxes (EBT) 24,000 32,000

— Taxes (T) 12,000 16,000

Earnings aftertaxes (EAT) $ 12,000 $ 16,000

Shares 8,000 24,000

Earnings per share (EPS) $1.50 $0.67


PPT 5-14 Table 5-5b Impact of financing plan on earnings pershare




5. EBIT ($60,000)

Earnings before interest and taxes (EBIT) $ 60,000 $ 60,000

— Interest (I) 12,000 4,000Earnings before taxes (EBT) 48,000 56,000

— Taxes (T) 24,000 28,000

Earnings aftertaxes (EAT) $ 24,000 $ 28,000

Shares 8,000 24,000

Earnings per share (EPS) $3.00 $ 1.17


PPT 5-15 Table 5-5c Impact of financing plan on earnings pershare




0 $ (0.75) $ (0.08)

12,000 0 $0.17

16,000 $0.25 $0.25

36,000 $1.50 $0.67

60,000 $3.00 $ 1.17

Leveraged Less LeveragedPlan (Conservative)

PlanEBIT EPS EPS

PPT 5-10

EBIT and EPS under both plans




PPT 5-16

Figure 5-4

Financing plans and earnings per share

4

3

2

1

0

-1

-2

120 25 50 75 100

EBIT ($ thousands)

EPS ($)

16

.25

Plan A

Plan B




Combined or Total Leverage

Represents maximum use of leverage

a in Sales a larger in EPS

Degree of Combined Leverage (DCL ) =

%age in EPS

%age in Sales

Short-cut formula:

DCL = DOL x DFL

PPT 5-19




Calculating the Degree of CombinedLeverage

DCL can be computed using the following formula:

OR

I FC VC P Q

VC P Q

)(

)( DCL

I FC TVC S TVC S

DCL

PPT 5 18




Sales (80,000 units @ $2) $160,000

Less: Variable costs ($0.80 per unit) 64,000

Contribution Margin 96,000

Less: Fixed costs 60,000

Earnings before interest and taxes $ 36,000 Less:Interest 12,000

Earnings before taxes 24,000

Less:Taxes 12,000

Earnings aftertaxes $ 12,000

Shares 8,000

Earnings per share $1.50

Operating

Leverage

= 2.67

Financial

Leverage

= 1.5

Combined

Leverage=

4

PPT 5-18

Operating, Financial and Combined Leverage under LeveragedPlan




Calculating EBIT at Indifference Point

Level of EBIT where the firm’s EPS are equal between 2financing plans

This is computed using the following formula:

Where:

EBIT is the operating income at the indifference point

I is the interest cost under plan A and B

S is shares outstanding under plan A and B

A B

B A A B

S S

I S I S

)( EBIT

**



Summary and Conclusions

Leverage uses fixed costs to magnify the profits (or losses) of

a business

Operating leverage refers to fixed operating costs, such as

lease or amortization expense

The degree of operating leverage (DOL) measures the %age

change in operating income from a %age change in sales

Financial leverage refers to interest expense on debt

The degree of financial leverage (DFL) measures the %age

change in earnings from a %age change in operating income

The higher the level of fixed costs, the greater the effect on

net income of an increase in sales revenue (This is the degree

of combined leverage (DCL))

PPT 5-22

18961198-designing-managing-marketing-channel.ppt

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