1 operating leverage financial leverage. 2 business risk the variability or uncertainty of a...
TRANSCRIPT
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• Operating Leverage
• Financial Leverage
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Business Risk
• The variability or uncertainty of a firm’s operating income (EBIT).
FIRMFIRMEBIT EPSStock-Stock-holdersholders
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Business Risk
Affected by:
• Sales volume variability
• Competition
• Cost variability
• Product diversification
• Product demand
• Operating Leverage
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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.
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Financial Risk
• 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.
FIRMFIRMEBIT EPSStock-Stock-holdersholders
6
Financial Leverage
• The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).
• A firm with relatively high fixed financing costs will experience more net income if EBIT changes.
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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).
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Operating Leverage
• What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?
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With high operating leverage, an increase in sales
produces a relatively larger increase in operating
income.
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Trade-off: Trade-off: the firm hasthe firm has
a higher breakeven a higher breakeven point. If sales are not point. If sales are not high enough, the firm high enough, the firm will not meet its fixedwill not meet its fixed
expenses!expenses!
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Breakeven point (units of output)
• QB = breakeven level of Q.
• F = total anticipated fixed costs.
• P = sales price per unit.
• V = variable cost per unit.
Breakeven Calculations
QB = FP - V
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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 -
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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.
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DOLs = % change in EBIT% change in sales
=
Degree of Operating Leveragefrom Sales Level (S)
Sales - Variable Costs EBIT
Q(P - V) Q(P - V) - F=
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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-holdersEBIT EPSSales
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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.
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DFL = % change in EPS% change in EBIT
EBIT EBIT - I
Degree of Financial Leverage
=
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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-holdersEBIT EPSSales
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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.
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DCL = DOL x DFL
Degree of Combined Leverage
=% change in EPS% change in Sales
Sales - Variable Costs EBIT - I
=
=
Q(P - V) Q(P - V) - F - I
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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-holdersEBIT EPSSales
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In-class Project:
• Based on the following information on Levered Company, answer these questions:
1) If sales increase by 1%, what should happen to operating income?
2) If operating income increases by 1%, what should happen to EPS?
3) If sales increase by 1%, what should be the effect on EPS?
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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
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Sales
EBITEPS
DOL
DFL
DCL
Leverage
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Degree of Operating Leverage from Sales Level (S)
1,400,000 - 800,000 350,000
= 1.714
=
DOLs = Sales - Variable Costs EBIT
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Levered Company
Sales
EBITEPS
DOL = 1.714
DFL =
DCL
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Degree of Financial Leverage
DFL = EBIT EBIT - I
= 350,000 225,000
= 1.556
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Levered Company
Sales
EBITEPS
DOL = 1.714
DFL = 1.556
DCL
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Degree of Combined Leverage
DCL = Sales - Variable Costs EBIT - I
1,400,000 - 800,000 225,000
= 2.667
=
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Levered Company
Sales
EBITEPS
DOL = 1.714
DFL = 1.556
DCL= 2.667
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Sales (110,000 units) 1,414,000
Variable Costs (808,000)
Fixed Costs (250,000)
EBIT 356,000 ( +1.714%)
Interest (125,000)
EBT 231,000
Taxes (34%) (78,540)
Net Income 152,460
EPS $1.5246 ( +2.667%)
Levered Company1% increase in sales