05 analysis and impact of leverage.pdf

7/29/2019 05 Analysis and Impact of Leverage.pdf

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Analysis and Impact of Leverage


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What is Leverage?


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Two Types of LeverageOperating Leverage - affects a firms business risk.

Financial Leverage - affects a firms financial risk.


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Two Types of RiskBusiness Risk

relative dispersion (variability) in the firm's expected

earnings before interest and taxes

Financial Risk

direct result of the firm's financing decision. this risk applies to

(1) the additional variabilityin earnings available to the

firm's common shareholders; and

(2) the additional chance of insolvency borne by the

common shareholder caused by the use of financial

leverage,


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Business Risk Coefficient of Variation of Expected EBIT

The relative dispersion in the firm's EBIT stream, measured here by itsexpected coefficient of variation

Example:

L4D has an expected value of EBIT equal to 690,000 w/ an associated

standard deviation of 25,000

COHs expected EBIT is 912,000 w/ an associated standard deviation of

61,0000

Operating Leverage


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Business RiskAffected by:

Sales volume variability Competition

Product diversification

Operating leverage

Growth prospects Size


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Financial Risk Financing Leverage

means financing a portion of the firm's assets with securities bearing afixed (limited) rate of return in hopes of increasing the ultimate return

to the common stockholders.


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Break-Even Analysis Break-even quantity output

results in an EBIT level equal to ___?___.

Use of the break-even model

(1) to determine the quantity of output that must be sold to cover all

operating costs, as distinct from financial costs, and (2) to calculate the EBIT that will be achieved at various output levels.


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Break-Even Analysis Essential Elements of the Break-Even Analysis:

Fixed Cost

Variable Cost


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Fixed Cost Total fixed costs are independent of the quantity of product

produced and equal some constant dollar amount.


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Units Produced and Sold

Cost

(Php)

Fixed-Cost Behavior over Relevant Range of Output


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Variable Cost Total variable costs are computed by taking the variable cost per unit

and multiplying it by the quantity produced and sold

The break-even model assumes proportionality between total

variable costs and sales. Thus, if sales rise by 10 percent, it is

assumed that variable costs will rise by 10 percent.


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Cost(Php)

Variable-Cost Behavior over Relevant Range of Output

Units Produced and Sold


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QuestionWhat happens if the firm increases its fixed

operating costs and reduces (or eliminates) itsvariable costs?


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Total Revenue and Volume of OutputTotal Revenue

Total sales dollars

Volume of Output

The firm's level of operation expressed either in sales dollars oras units of output.


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Finding the Break-Even Point Finding the break-even point in terms of units of production can be

accomplished in several ways.


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SCENARIO DBZ Company manufactures several different products, and has

observed over a lengthy period that its product mix is ratherconstant.

This allows management to conduct its financial planning by use of a

"normal" sales price per unit and "normal" variable cost per unit.(both are calculated from the constant product mix this is likeassuming that the product mix is one big product)

The selling price is $10 and the variable cost is $6.

Total fixed costs for the firm are $100,000 per year.

What is the break-even point in units produced and sold for thecompany during the coming year?


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Trial and Error Analysis


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Contribution-Margin Analysis difference between the unit selling price and unit variable costs

"contribution" in the present context means contribution to the

coverage of fixed operating costs.


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Algebraic AnalysisBreakeven point (units of output)

QB = breakeven level of Q (# of units sold)

F = total anticipated fixed costs.P = sales price per unit.

V = variable cost per unit.

QB =F

P - V


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Breakeven Calculations (Sales dollars)Breakeven point (sales dollars)

S* = breakeven level of sales.F = total anticipated fixed costs.S = total sales.VC = total variable costs.

S* =F

VC

S1 -


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Breakeven Calculations (Sales dollars)Analytical Statement

Sales $300,000

Total variable cost 180,000

Revenue before fixed cost 120,000

Total fixed cost 100,000

EBIT 20,000


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Graphic Representation


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Degree of Operating LeverageOperating leverage: by using fixed operating costs, a

small change in sales revenue is magnified into alarger change in operating income.

This multiplier effect is called the degree of

operating leverage.


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Degree of Operating LeverageAssuming DBZ is currently operating at an annual

sales level of $300,000 (base sales level at t = 0)

Question: How will DBZ's EBIT level respond to a

positive 20 percent change in sales at

t +1 ?


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DOLs =% change in EBIT

% change in sales

change in EBIT

EBIT

change in salessales

=

Degree of Operating Leverage from Sales Level (S)


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Degree of Operating Leverage from Sales Level (S)If we have the data, we can use this formula:

S

VC _SVCF

=

DOLs =Sales - Variable Costs

EBIT

Q(P - V) _

Q(P - V) - F

=


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Degree of Financial Leverage Financial leverage: by using fixed cost financing, a small change in

operating income is magnified into a larger change in earnings pershare.

This multiplier effect is called the degree of financial leverage.


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Degree of Financial LeverageLet us assume that the DBZ have calculated that $200,000 is

needed to purchase the necessary assets to conduct thebusiness.

Three possible financing plans have been identified for raising

the $200,000; Plan A: no financial risk is assumed: The entire $200,000 is raised by

selling 2,000 common shares, each with a $100 par value.

Plan B: a moderate amount of financial risk is assumed: 25 percent ofthe assets are financed with a debt issue that carries an 8 percent annual

interest rate. Plan C: would use the most financial leverage: 40 percent of the assels

would be financed with a debt issue costing 8 percent


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DFL = % change in EPS% change in EBIT

change in EPSEPS

change in EBIT

EBIT

Degree of Financial Leverage

=


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Degree of Financial Leverage If we have the data, we can use this formula:

DFL =EBIT

EBIT - I


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Degree of Combined LeverageCombined leverage: by using operating leverage and

financial leverage, a small change in sales is magnified intoa larger change in earnings per share.

This multiplier effect is called the degree of combinedleverage.


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DCL = DOL x DFL

Degree of Combined Leverage

=% change in EPS

% change in Sales

change in EPS

EPSchange in Sales

Sales

=


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DCL =Sales - Variable Costs

EBIT - I

Degree of Combined Leverage If we have the data, we can use this formula:


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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

=

05 analysis and impact of leverage.pdf

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