operating and financial leverages_final

8/4/2019 Operating and Financial Leverages_final

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OPERATING AND

FINANCIAL LEVERAGESBy

Kartikeya kasera 112

Deepak mehta 114Gaurav kakkad 207

Aditi mehta 208

Chittesh khilnani 310

Nachiket kulkarni 311


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LEVERAGE: THE BASIC PRINCIPLE


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Operating cost breakup

Fixedcost

Variablecost

TOTALOPERATING

COST


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OPERATING PROFIT(EBIT)

SALESVARIABLE

COST FIXED COST

OPERATING

PROFIT

i.e, SVCFC =EBIT


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BREAK EVEN ANALYSIS

BREAK EVEN POINT (BE)- NO profit NO loss.


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Condition for Sales Break-Even Point

A general break-even point for a multiproduct

firm cant be done using BQP.

Assuming that sales of each product are a

constant proportion of the firms total sales


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BREAK EVEN ANALYSIS (CONTD.)

QBE=FC/(P-V)

SBE=FC/[1-(VC/S)]P= price per unit

V= variable cost

FC= Fixed costQBE=break even

quantity

SBE=break even salec


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EXAMPLEConsider a firm that produces high quality childs bicycle helmet

that sells for Rs.50 a unit. The company has annual fixed

operating cost of Rs. 100,000 and a variable cost of Rs. 25 perunit.

Break even quantity

point:

QBE = FC/(P-V)

QBE = 100,000/(50-25)

QBE =4000

i.e. sales of Rs 200,000

Break even sales

point:

SBE = FC/ [1-(VC/S)]

SBE = 100,000/(1-.5)

SBE = 200,000

i.e. 4000 units


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OPERATING LEVERAGE


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Operating Leverage

It is the firms ability to use

fixed operating costs to

magnify the effect of changes

in sales and its earning beforeinterest and taxes(EBIT).

Fixed operating cost-do not

change as volumes change

Variable operating cost-vary

directly with level of output.


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FC V/S VC

Fixed cost Variable cost

Depreciation of land and

building

Raw material

insurance Direct labor

Utility bills partly Utility bill partly

Cost of management Direct selling commissions

General administration

expenses


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Firm F Firm V Firm 2F

Sales $10,000 $11,000 $19,500

Operating Costs

Fixed 7,000 2,000 14,000

Variable 2,000 7,000 3,000

Operating Profit (EBIT) $1,000 $2,000 $2,500

Operating Leverage ratios

FC/Total Costs 0.78 0.22 0.82

FC/Sales 0.70 0.18 0.72

Three firms after 50% increases in sales in following years

Firm F Firm V Firm 2F

Sales $15,000 $16,500 $29,500

Operating Costs

Fixed 7,000 2,000 14,000

Variable 3,000 10,500 4,500

Operating Profit (EBIT) $5,000 $4,000 $10,750

% Change in EBIT 400% 100% 330%

E

X

A

M

PL

E


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DOL-Degree of operating

leverage


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Degree of Operating Leverage (DOL)

The percentage change in a firms operating

profit (EBIT) resulting from a 1 percent

change in output (sales).

DOL Q units=% change in EBIT

% change in sales

= EBIT/EBIT

Q/Q


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Calculations (contd.)

EBIT= Q(S-V)-F

EBIT= Q(S-V)

DOL Q units= Q(S-V) x Q

Q(S-V)-F Q

DOL Q units= Q(S-V)

Q(S-V)-F

= Q = Q

Q-F/(S-V) Q - QBE


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To summarizeDOLQ units

DOL for a single-product firm.P = Price per unit V = Variable costs per unit

FC = Fixed costs Q = Quantity (units)

produced and sold

DOLQ units =Q (P - V)

Q (P - V) - FC

= Q

Q - QBE


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Computing the DOL for multiproduct

firm.

DOL for a multi-product firm.

DOLsales (R rupees) =R - VC

R - VC - FC

=EBIT + FC

EBIT


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DOL and Break-Even Point

QUANTITY

PRODUCED AND SOLD

(Q)

OPERATING PROFIT

(EBIT)

DEGREE OF

OPERATING

LEVERAGE (DOL)

0 ` -1,00,000 0.00

1,000 -75,000 -0.332,000 -50,000 -1.00

3,000 -25,000 -3.00

0 Infinite

5,000 25,000 5.006,000 50,000 3.00

7,000 75,000 2.33

8,000 1,00,000 2.00


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DOL and Break-Even Point

The firms relative proximity

to BE point determines its

DOL.


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Interpretation of DOL

DOL is a quantitative measure of the sensitivity of afirms operating profit to a change in the firms sales.

The closer that a firm operates to its break-even point,the higher is the absolute value of its DOL.

When comparing firms, the firm with the highest DOL isthe firm that will be most sensitive to a change insales.

i.e. it shows the change in EBIT with every 1% changein sales.


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Guidelines for firms

General rule:

Dont operate under condition of high DOL

At high DOL small drop in sale leads tooperating losses

DOL magnifies impact of variable sales and

variable production cost.


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FINANCIAL LEVERAGE


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Financial Leverage

Financial Leverage- ability of a firm to use fixedfinancial charges to magnify the effect of changes inEBIT on the earning per share.

Financial leverage is employed in hope to increase thereturn to common stock holder.


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COMPARISON

LEVERAGE OPERATING FINANCIAL

Firms control Not much Considerable

Magnifies

Effect on change in

sales Operating profit

Change in

Operating profit Earning per share

Leverage used on Fixed operating cost

(associated with production)

Fixed financing cost

(interest on debt)


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Calculation of earning per share(EPS)

EPS = (EBITI)(1-t)- PD .

NS

Where,

I = Annual interest paid on debt.

PD = Annual dividend paid to preference shareholders.

t = Corporate tax rate.

NS = Number of shares of common stock.


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Example

Common stock debt Preferred stock

No debt and no PS No PS No debt

Debt $ 5 M @ 12% PS $ 5 M @ 11%

EBIT $ 2700000 $ 2700000 $ 2700000

I - 600000 -

EBT $2700000 $2100000 $2700000

EBT*t(corporate

tax)

1080000 840000 1080000

EAT $1620000 $1260000 $1620000

PD - - 550000

EACS(earning

available)

$1620000 $1260000 $1070000

NS 300000 200000 200000

EPS $ 5.4 $6.30 $5.35


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0

EBIT-EPS Chart

EBIT ($ thousands)

Earn

ingsperShare($)

0

1

2

3

4

5

6

Common

Debt

Indifference point

between preferred

stockand common

stockfinancing

Preferred

Indifference pointbetween debtand common

stockfinancing


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Indifference point

Indifference point: the point between two

alternative where EPS is same.

Away from the point either of the two will be

preferable.


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EBIT-EPS Chart

0 100 200 300 400 500 600 700

EBIT ($ thousands)

Earn

ingsperShare($)

0

1

2

3

4

5

6

Common

Debt

Indifference point

between debt andcommon stock

financing


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Effect on RISK

Graph

Safe distribution-negligible risk of EBIT falling below

indifference point

Firm can go for debt financing to increase EPS

Risky distribution-considerable risk of EBIT falling

below indifference point

Firm needs to be cautious to go for debt financing


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GRAPHICAL EXPLANATION


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DFL, Financial Risk and DTL


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Degree of Financial Leverage

A quantitative measure of the sensitivity of a firms earningsper share to a change in the firms operating profit.

Defining Value given by:

DFL (at EBIT of X dollars) = % change in EPS

% change in EBIT

EPS= Earnings per share

EBIT=Operating profit


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Degree of Financial Leverage

Computing Value given by:

DFL(EBIT of X dollars) = EBIT

EBITI[ PD / (1 - t ) ]

I = Annual Interest Paid

PD = Annual preferred dividend paid

t = corporate tax rate


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DFL and Financial Risk

Financial Risk comprises of

possible insolvency

In situation of inadequate cash

Inadequate EPS

As a firm increases the proportion of fixed cost

financing in its capital structure, fixed cash

outflows increase.

As a result, the probability of cash insolvencyincreases.

E l fi i l i k


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Frame A : Forecast income

statement information

Firm A

(100% Equity)

Firm B

(50% Equity)

Expected EBIT $80,000 $80,000

Interest --- 30,000

E[EBT] $80,000 $50,000

E[EBT] X t 32,000 20,000

E[EACS] $48,000 $30,000

NS 4,000 2,000

E[EPS] $12.00 $15.00

Frame B: Risk Components

EPS $6.00 $12.00

CVEBIT=EBIT/E(EBIT) 0.50 0.50

DFL 1.00 1.60

CVEPS=EPS/E(EPS) 0.50 0.80

Example: financial riskAssumption: expected EBIT = $ 80,000 and EBIT=$ 40000 , t=40%


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Conclusion of the example

Total Risk = Financial Risk + Business Risk

The coefficient of variation of EPS is a measure of total firmrisk.

It is given by:

CV EPS = EPS / E(EPS)

The coefficient of variation of EBIT is a measure offirmSBusiness risk.

It is given by:

CV EBIT = EBIT / E(EBIT) Difference of above two is Relative financial risk

= CV EPSCV EBIT


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HOW FIRM CAN CONTROL RISK

WITHOUT COMPROMISING EPS.BUSINESS RISK FINANCIAL RISK OVERALL RISK

LOW HIGH MEDIUM

HIGH LOW MEDIUM

MEDIUM MEDIUM MEDIUM


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RISK MAGNIFYING EFFECT OF

DFL

Total firm risk:-

= CV EBIT x DFL E(EBIT)= Business RiskX Financial Risk

Thus, by applying financial leverage, DFL willmagnify the impact of business risk on thevariability of EPS.

DFLs magnitude determines amount of additionalrisk induced by the use of financial leverage.


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Total Leverage

It is the use of both fixed operating and fixed

financing costs by the firm

Thus it is the combination of both operating andfinancial leverage

Degree of Total Leverage

It is the quantitative measure of the total sensitivityof a firms earnings per share to a change in the

firms sales


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DTL is given by:DTL (at Q units or S dollars of sales) = % change in EPS

% change in sales

Computationally,DTL (at Q units or S dollars of sales) = DOL (at Q units or S dollars of sales)

x DFL ( EBIT of X dollars)DTL (at Q units ) = Q ( PV )

Q(PV)FCI[PD / (1 - t )]

DTL( S dollars of sales) = EBIT + FC

EBITI[PD / ( 1 - t )]

Degree of total leverage: formula


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DTL and Total Firm Risk

Operating leverage and financial leverage can becombined in a no. of different ways to obtain a desirabledegree of total leverage and level of total firm risk.

High business risk can be offset with low financial risk

and vice versa. The proper overall level of firm risk involves a tradeoff

between total firm risk and expected return.

This trade off must be made in keeping with the objective

of maximizing shareholder value.


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COVERAGE RATIOS &

CASH INSOLVENCY

OPERATING AND FINANCIAL LEVERAGE


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Why Coverage Ratio?

To analyze cash-flow ability of a firm to service fixedfinancial charges to determine the appropriate financial

leverage for the firm.

Debt capacity: It is maximum debt & other fixed charge

financing that a firm can adequately service.

If the expected future cash flows are higher and stable, thenthe debt capacity of firm will be higher.

Coverage ratios help in ascertaining the debt capacity.

OPERATING AND FINANCIAL LEVERAGE


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Why Coverage Ratio? (cont.)

The fixed financial charges must be met with cash

which may otherwise lead to cash insolvency.

Includes Principal payments on debt

Interest payments on debt

Financial lease payments, etc

OPERATING AND FINANCIAL


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Coverage Ratios

In computation of coverage ratios, EBIT is used as a rough

measure of cash flow available to cover fixed financial charges

Types of Coverage ratios:-

Interest Coverage Ratio

Debt-Service Coverage Ratio

OPERATING AND FINANCIAL

LEVERAGE


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Interest Coverage Ratio

Interest Coverage Ratio(ICR) =

ICR of 1 indicates that the earnings are just sufficient to satisfy

the interest burden without any cushion for change in EBIT.

No generalization. ICR at the most can be industry specific.

If the business is highly stable- Low ICR

Highly cyclical businessesHigh ICR

Limitation of ICR:- Does not account for

debts principle service.

EBITInterest Expenses

Debt-Service Coverage Ratio-


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Debt Service Coverage Ratio

Overcoming ICR Limitation

Debt-Service

Coverage Ratio

The debt-service burden may be defined as the cash required

to meet the interest expenses & principal payments.

If for example the Debt-Service Coverage Ratio is 2, then even

if EBIT falls to 50% , the firm will meet interest and principal

payments liability.

EBIT

Interest Expenses + Principal payments

1Tax Rate


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Probability of Cash Insolvency

The vital question for a firm

is not so much whether a coverage ratio will fall below 1

But what are the chances of cash insolvency.

Cash Insolvency

It helps us assess that if all the sources of payments like

Expected earnings

Cash flow factors such as purchase or sale of assets

liquidity of the firm

dividend payments

seasonal patterns

are collectively sufficient or deficient to meet these fixed obligation.

If the probability is low it implies that an additional cash drain

may cause cash insolvency.


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Surveying Investment Analysts and Lenders

As the investment analysts, investors and

investment bankers are in the business of

recommending stocks, it is advisable to obtain

their views on the appropriate amount offinancial leverage.

They are able to explain the market prospects

with respect to financial leverages


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THANK YOU

operating and financial leverages_final

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