Operating Leverage Financial Leverage Chapter 15 Analysis and Impact of Leverage What is Leverage? Two concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firms business risk. 2) Financial Leverage - affects a firms financial risk. Business Risk The variability or uncertainty of a firms operating income (EBIT). Business Risk The variability or uncertainty of a firms operating income (EBIT). EBIT Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM EBIT Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM EBIT EPS Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM EBIT EPS Stock-holders Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM EBIT EPS Stock-holders Business Risk Affected by: Sales volume variability Competition Product diversification Operating leverage Growth prospects Size 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. EBIT Operating Leverage Financial Risk The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. Financial Risk The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders Financial Risk The variability or uncertainty of a firms earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders Financial Leverage The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock). EPS Financial Leverage 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. Quantity $ Breakeven Analysis Quantity $ Total Revenue 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). Quantity $ Total Revenue Quantity { $ Total Revenue Total Cost FC Quantity { $ Total Revenue Total Cost FC Q1Q1 + - } EBIT Quantity { $ Total Revenue Total Cost FC Break-even point Q1Q1 + - } EBIT Operating Leverage What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? Quantity { $ Total Revenue Total Cost FC Break- even point Q1Q1 + - } EBIT Quantity { $ Total Revenue Total Cost = Fixed FC Break-even point } Q1Q1 + - EBIT With high operating leverage, an increase in sales produces a relatively larger increase in operating income. Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q1Q1 + - EBIT Quantity { $ Total Revenue Total Cost = Fixed FC Break- even point } Q1Q1 + - EBIT Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses! Breakeven Calculations Breakeven point (units of output) Q B = F P - V Breakeven point (units of output) Q B = breakeven level of Q. F = total anticipated fixed costs. P = sales price per unit. V = variable cost per unit. Breakeven Calculations Q B = F P - V Breakeven Calculations S* = F VC S 1 - Breakeven point (sales dollars) S* = breakeven level of sales. F = total anticipated fixed costs. S = total sales. VC = total variable costs. Breakeven Calculations S* = F VC S 1 - Analytical Income Statement sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income 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. DOLs = % change in EBIT % change in sales Degree of Operating Leverage from Sales Level (S) DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales = Degree of Operating Leverage from Sales Level (S) If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs EBIT What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales What does this tell us? If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales 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. This multiplier effect is called the degree of financial leverage. DFL = % change in EPS % change in EBIT Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT Degree of Financial Leverage = If we have the data, we can use this formula: Degree of Financial Leverage DFL = EBIT EBIT - I If we have the data, we can use this formula: What does this tell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. What does this tell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales What does this tell us? If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales 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. Degree of Combined Leverage DCL = DOL x DFL Degree of Combined Leverage DCL = DOL x DFL Degree of Combined Leverage % change in EPS % change in Sales = DCL = DOL x DFL Degree of Combined Leverage = % change in EPS % change in Sales change in EPS EPS change in Sales Sales = Degree of Combined Leverage If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - I If we have the data, we can use this formula: Degree of Combined Leverage If we have the data, we can use this formula: DCL = Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I = What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales What does this tell us? If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales In-class Project: Based on the following information on 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? Levered Company Sales (100,000 units)$1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Common shares outstanding 100,000 EPS Financial leverage Operating Income Sales Operating leverage Levered Company Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT EBIT Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = DOLs = Sales - Variable Costs EBIT EBIT Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = = DOLs = Sales - Variable Costs EBIT EBIT EPS Operating Income Sales Levered Company EPS Operating Income Sales Operating leverage Levered Company EPS Operating Income Sales Operating leverage 10% Levered Company EPS Operating Income Sales Operating leverage 10% 17.14% Levered Company Degree of Financial Leverage DFL = EBIT EBIT EBIT - I Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000 Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000 = 1.556 EPS Operating Income Sales Levered Company EPS Operating Income Sales Financial leverage Levered Company EPS Financial leverage Operating Income Sales 10% Levered Company EPS Financial leverage Operating Income Sales 10% 15.56% Levered Company EPS Financial leverage Operating Income Sales 10% 15.56% Levered Company Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 = Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 = = EPS Operating Income Sales Levered Company EPS Operating Income Sales Operating leverage Levered Company EPS Financial leverage Operating Income Sales Operating leverage Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% Levered Company EPS Financial leverage Operating Income Sales Operating leverage 10% 26.67% Levered Company EPS Financial leverage Operating Income Sales 10% 26.67% Operating leverage Levered Company Sales (110,000 units)1,540,000 Sales (110,000 units)1,540,000 Variable Costs (880,000) Variable Costs (880,000) Fixed Costs (250,000) Fixed Costs (250,000) EBIT 410,000 ( %) EBIT 410,000 ( %) Interest (125,000) Interest (125,000) EBT 285,000 EBT 285,000 Taxes (34%) (96,900) Taxes (34%) (96,900) Net Income 188,100 Net Income 188,100 EPS $1.881 ( %) EPS $1.881 ( %) Levered Company 10% increase in sales