INTERVIEW

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Chapter

McGraw-Hill/Irwin

Operating and Financial Leverage

Chapter Outline

What is leverage?
Operating leverage.
Financial leverage.
Potential profits or increased risk?

What is Leverage?

Use of special forces and effects to magnify or produce more than the normal results from a given course of action.
Can produce beneficial results in favorable conditions.
Can produce highly negative results in unfavorable conditions.

Leverage in Business

Determining type of fixed operational costs.
Plant and equipment
Eliminates labor in production of inventory.
Expensive labor
Lessens opportunity for profit but reduces risk exposure.
Determining type of fixed financial costs.
Debt financing
Substantial profits but failure to meet contractual obligations can result in bankruptcy.
Selling equity
Reduces potential profits but minimize risk exposure.

Operating Leverage

The extent to which fixed assets and associated fixed costs are utilized in a business.
Operational costs include:
Fixed
Variable
Semivariable

Break-Even Chart: Leveraged Firm

Break-Even Analysis

The break-even point is at 50,000 units, where the total costs and total revenue lines intersect.

Units = 50,000 .

Total Variable Fixed Costs Total Costs Total Revenue Operating Income

Costs (TVC) (FC) (TC) (TR) (loss)

(50,000 X $0.80) (50,000 X $2)

$40,000 $60,000 $100,000 $100,000 0

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Break-Even Analysis (cont’d)

The break-even point can also be calculated by:

Fixed costs = Fixed costs = FC

Contribution margin Price – Variable cost per unit P – VC

i.e. $60,000 = $60,000 = 50,000 units

$2.00 - $0.80 $1.20

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Volume-Cost-Profit Analysis: Leveraged Firm

A Conservative Approach

Some firms choose not to operate at high degrees of operating leverage.
More expensive variable costs may be substituted for automated plant and equipment.
This approach may cut into potential profitability of the firm as shown in Figure 5-2.

Break-Even Chart: Conservative Firm

Volume-Cost-Profit Analysis: Conservative Firm

The Risk Factor

Factors influencing decision on maintaining a conservative or a leveraged stance include:
Economic condition.
Competitive position within industry.
Future position – stability versus market leadership.
Matching an acceptable return with a desired level of risk.

Cash Break-Even Analysis

Helps in analyzing the short-term outlook of a firm.
Non-cash items are excluded:
Depreciation
Sales (accounts receivable rather than cash)
Purchase of materials
Accounts payable

Degree of Operating Leverage (DOL)

Percentage change in operating income
Occurs as a result of a percentage change in units sold.
Computed only over a profitable range of operations.
Directly proportional to the firm’s break-even point.

DOL = Percent change in operating income

Percent change in unit volume

Operating Income or Loss

Computation of DOL

Leveraged firm:

DOL = Percent change in operating income = $24,000 X 100

Percent change in unit volume $36,000

20,000 X 100

80,000

= 67% = 2.7

25%

Conservative firm:

DOL = Percent change in operating income = $8,000 X 100

Percent change in nit volume $20,000

20,000 X 100

80,000

= 40% = 1.6

25%

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Algebraic Formula for DOL

DOL = Q (P – VC)

Q (P – VC) – FC

Where,

Q = Quantity at which DOL is computed.
P = Price per unit.
VC = Variable costs per unit.
FC = Fixed costs.
For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000:

DOL = 80,000 ($2.00 - $0.80) ;

80,000 ($2.00 - $0.80) - $60,000

= 80,000 ($1.20) = $96,000 ;

80,000 ($1.20) - $60,000 $96,000 - $60,000

i.e. DOL = 2.7

Limitations of Analysis

Weakening of price in an attempt to capture an increasing market.
Cost overruns when moving beyond an optimum-size operation.
Relationships are not fixed.

Nonlinear Break-Even Analysis

Financial Leverage

Reflects the amount of debt used in the capital structure of the firm.
Determines how the operation is to be financed.
Determines the performance between two firms having equal operating capabilities.

BALANCE SHEET

Assets Liabilities and Net Worth

Operating leverage Financial leverage

Impact on Earnings

Examine two financial plans for a firm, where $200,000 is required to carry the assets.

Total Assets = $200,000

Plan A (leveraged) Plan B (conservative)

Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)

Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)

Total financing $200,000 $200,000

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Impact of Financing Plan on Earnings per Share

Financing Plans and Earnings per Share

Degree of Financial Leverage

DFL = Percent change in EPS

Percent change in EBIT

For the purpose of computation, it can be restated as:

DFL = EBIT .

EBIT – I

Plan A (Leveraged):

DFL = EBIT = $36,000 = $36,000 = 1.5

EBIT – I $36,000 - $12,000 $24,000

Plan B (Conservative):

DFL = EBIT = $36,000 = $36,000 = 1.1

EBIT – I $36,000 - $4,000 $32,000

Limitations to the Use of Financial Leverage

Beyond a point, debt financing is detrimental to the firm.
Lenders will perceive a greater financial risk.
Common stockholders may drive down the price.
Recommended for firms that are:
In an industry that is generally stable.
In a positive stage of growth.
Operating in favorable economic conditions.

Combining Operating and Financial Leverage

Combined leverage: when both leverages allow a firm to maximize returns.
Operating leverage:
Affects the asset structure of the firm.
Determines the return from operations.
Financial leverage:
Affects the debt-equity mix.
Determines how the benefits received will be allocated.

Combined Leverage Influence on the Income Statement

Combining Operating and Financial Leverage

Operating and Financial
Leverage

Degree of Combined Leverage

Uses the entire income statement.
Shows the impact of a change in sales or volume on bottom-line earnings per share.

DCL = Percentage change in EPS ;

Percentage change in sales (or volume)

Using data from Table 5-7:

Percent change in EPS = $1.50 X 100

Percent change in sales $1.50 = 100% = 4

$40,000 X 100 $25%

$160,000

Degree of Combined Leverage (cont’d)

DCL = Q (P – VC) ,

Q (P – VC) – FC – I

From Table 5-7,

Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.

DCL = 80,000 ($2.00 - $0.80) =

80,000 ($2.00 - $0.80) - $60,000 - $12,000

= 80,000 ($1.20) =

80,000 ($1.20) - $72,000

DCL = $96,000 = $96,000 = 4

$96,000 - $72,000 $24,000