slide 1 leverage operating leverage: the use of fixed operating costs as opposed to variable...
TRANSCRIPT
Slide 1
Leverage Operating Leverage:
The 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
Financial Leverage: The use of fixed-cost sources of financing (debt,
preferred stock) rather than variable-cost sources (common stock)
Slide 2
Leverage Analysis Operating Leverage
Affects a firm’s business risk Business risk is the variability or uncertainty of a
firm’s operating income (EBIT) Financial Leverage
Affects a firm’s financial risk Financial risk is the variability or uncertainty of a
firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage
Slide 3
Breakeven Analysis Illustrates 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 Terms:
P: price per unit, Q: quantity produced, V: variable costs per unit, VC; total variable costs, F; total fixed costs, TC: total cost (VC+F), S: sales ($)
Slide 4
Quantity
$
Total Revenue(PQ)
Breakeven Analysis
Slide 5
Costs
Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions)
Slide 6 Quantity
{
$
Total Revenue
Total Cost(QV)+F or
VC+F
FC
Q1
+
-
}
Breakeven Analysis
EBIT
Breakeven EBIT
Slide 7
Operating Leverage
What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?
Slide 8
Quantity
$
Total Revenue
Total Cost= FixedFC
Q1
+
-
EBIT
Breakeven Analysis
Breakeven EBIT
{}
With high operating leverage, an increase in sales produces a relatively larger increase in
operating income.
Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!
Slide 9
Breakeven Calculations – Quantity
Marginon Contributi theis V-P
unitper cost variable:V
unitper price sales :P
costs fixed danticipate total:F
Q of levelbreakeven :Q
whereV-P
F=Q
B
B
Slide 10
Breakeven Calculations – Sales
constant be toassumed is S
VC that Note
costs variable total:VC
sales total:S
costs fixed total:F
sales of levelbreakeven :S*
whereS
VC-1
F=*S
Slide 11
sales
- variable costs
- fixed costs
operating income (EBIT)
- interest
EBT
- taxes
net income
} contribution margin
Analytical Income Statement
EBT (1 – t) = Net Income,
so,
Net Income / (1 – t) = EBT
Slide 12
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
Slide 13
Degree of Operating Leveragefrom Sales Level (S)
salessalesin change
EBITEBITin change
salesin change %
EBITin change %SDOL
Above calculation requires two analytical income statements, one for the base period and one for the following period using the new level of sales
Slide 14
If we have the base level data, we can use this formula:
Degree of Operating Leveragefrom Sales Level (S)
FVPQ
VPQDOLS
)(
)(
EBIT
Costs Variable - Sales
Implicit assumption is that Variable Costs / Sales and Fixed Costs stay the constant
If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT) and vice versa
%Δ in EBIT = DOLSales x %Δ in Sales
Slide 15
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 (EPS)
This “multiplier effect” is called the degree of financial leverage
Slide 16
Degree of Financial Leverage
EBITEBITin change
EPSEPSin change
EBITin change %
EPSin change %EBITDFL
Each financing or capital structure (relative use of debt and equity) alternative will have a different degree of financial leverage (DFL)
Slide 17
Degree of Financial Leverage
Instead of calculating DFL for each alternative capital structure we can use the following formula with the base EBIT and differing interest expenses
Note that interest expense would be based on how much debt is used financing the assets of the firm
If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share and vice versa
%Δ in EPS = DFLEBIT x %Δ in EBIT
IEBIT
EBITDFLEBIT
Slide 18
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
Slide 19
Degree of Combined Leverage
SalesSalesin change
EPSEPSin change
Salesin change %
EPSin change %
)()(
S
S
EBITSS
DCL
DCL
DFLXDOLDCL
Slide 20
Degree of Combined Leverage
If we have the base level data, we can use this formula:
If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share
%Δ in EPS = DCLSales x %Δ in Sales
IFVPQ
VPQDCL
DCL
S
S
)(
)(I - EBIT
Costs Variable - Sales
Slide 21
Example Based on the following information on a
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?
Slide 22
Levered Company – Data
Sales (100,000 units) $1,400,000
Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Shares outstanding 100,000
Slide 23
Sales
EBITEPS
DOL
DFL
DCL
Leverage
Slide 24
Levered Company – Base Level Data
Sales (100,000 units) $1,400,000
Variable Costs ($800,000)
Fixed Costs ($250,000)
EBIT (Operating Income) $350,000)
Interest paid ($125,000)
EBT $225,000
Tax @ 34% ($75,500)
EAT (Net Income) $148,500
EPS = $148,500 / 100,000 = $1.485
Slide 25
Degree of Operating Leverage from Sales Level (S)
714.1000,350
000,80000,400,1EBIT
Costs Variable - Sales
D
S
DOL
DOL
Answer to part 1: %Δ in EBIT = DOLSales x %Δ in Sales %Δ in EBIT = 1.714 x 10% = 17.14%
Slide 26
Degree of Financial Leverage
556.1000,225
000,350
EBIT
EBIT
DFL
IEBIT
EBITDFL
Answer to part 2: %Δ in EPS = DFLEBIT x %Δ in EBIT %Δ in EPS = 1.556 x 10% = 15.56% %Δ in EPS = 1.556 x 17.14% = 26.67% (cumulative
impact of part 1
Slide 27
Degree of Combined Leverage
667.2000,225
000,800000,400,1I - EBIT
Costs Variable - Sales
S
S
DCL
DCL
Answer to part 3: Alternatively DCL = DOL x DFL DCL = 1.714 x 1.556 = 2.667 %Δ in EPS = 2.667 x 10% = 26.67%
Slide 28
Levered Company
Sales
EBITEPS
DOL = 1.714
DFL =1.556
DCL = 2.667
Slide 29
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 sales