Operating and Financial LeverageChapter 5

Chapter 5 - OutlineWhat is Leverage?Break-Even (BE) PointOperating LeverageFinancial LeverageLeverage Means RiskCombined or Total Leverage

What is Leverage?Use of special forces and effects to magnify or produce more than the normal results from a given course of action

Leverage involves using fixed costs to magnify the potential return to a firm

Can produce beneficial results in favorable conditionsCan produce highly negative results in unfavorable conditions

Leverage in a BusinessDetermining type of fixed operational costsPlant and equipmentCan reduce expensive labor in production of inventoryExpensive laborLessens opportunity for profit but reduces risk exposureDetermining type of fixed financial costsDebt financingCan produce substantial profits, but failure to meet contractual obligations can result in bankruptcySelling equityMay reduce potential profits for existing shareholders, but reduces their risk exposure

Break-Even (BE) PointQuantity where Total Revenue equals Total CostCompany has no Profit or LossBE = FC / (P VC)A leveraged firm has a high BE pointA non-leveraged firm has a low BE point

FIGURE 5-1Break-even chart: Leveraged firm

FIGURE 5-2Break-even chart: Conservative firm

TABLE 5-2Volume-cost-profit analysis: Leveraged firm

TABLE 5-3Volume-cost-profit analysis: Conservative firm

FIGURE 5-3Nonlinear break-even analysis

Operating LeverageMeasure of the amount of fixed operating costs used by a firm.Degree of Operating Leverage (DOL) = % in EBIT (or Operating Income) / % in Sales

DOL = Q(P-VC) / (Q(P-VC) FC)

Operating Leverage measures the sensitivity of a firms operating income to a in sales.

TABLE 5-4Operating income or loss

Financial LeverageMeasure of the amount of debt used by a firmDegree of Financial Leverage (DFL) = % in EPS / % in EBIT (or Operating Income)

DFL = EBIT / (EBIT I)

Financial Leverage measures the sensitivity of a firms earnings per share to a in operating income

Leverage Means RiskLeverage is a double-edged swordIt magnifies profits as well as lossesAn aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point)A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)Many Japanese firms tend to be highly leveraged

FIGURE 5-4Financing plans and earnings per share

TABLE 5-5Impact of financing plan on earnings per share

Financial LeverageReflects the amount of debt used in the capital structure of the firmDetermines how the operation is to be financedDetermines the performance between two firms having equal operating capabilities

BALANCE SHEETAssets Liabilities and Net Worth Operating leverage Financial leverage

TABLE 5-6Income statement

Combined or Total LeverageRepresents maximum use of leverageDegree of Combined or Total Leverage (DCL or DTL) = % in EPS / % in SalesDCL= Q(P-VC)/(Q(P-VC)-FC-I)= (S-TVC) /( S-TVC FC- I)Short-cut formula:DCL or DTL = DOL x DFL

TABLE 5-7Operating and financial leverage

Combining Operating and Financial LeverageCombined leverage: when both leverages allow a firm to maximize returnsOperating leverage:Affects the asset structure of the firmDetermines the return from operationsFinancial leverage:Affects the debt-equity mixDetermines how the benefits received will be allocated