operating and financial leverage chapter 5. chapter 5 - outline what is leverage? break-even (be)...

Operating and FinancialLeverage

Chapter 5

Chapter 5 - Outline

What is Leverage?Break-Even (BE) PointOperating LeverageFinancial LeverageLeverage Means RiskCombined or Total Leverage

What is Leverage?Use of special forces and effects to magnify

or produce more than the normal results from a given course of action

Leverage involves using fixed costs to magnify the potential return to a firm

Can produce beneficial results in favorable conditions

Can produce highly negative results in unfavorable conditions

Leverage in a BusinessDetermining type of fixed operational costs

Plant and equipmentCan reduce expensive labor in production of inventory

Expensive laborLessens opportunity for profit but reduces risk exposure

Determining type of fixed financial costsDebt financing

Can produce substantial profits, but failure to meet contractual obligations can result in bankruptcy

Selling equityMay reduce potential profits for existing shareholders, but

reduces their risk exposure

Break-Even (BE) PointQuantity where Total Revenue

equals Total CostCompany has no Profit or LossBE = FC / (P – VC)A leveraged firm has a high BE

pointA non-leveraged firm has a low BE

point

FIGURE 5-1Break-even chart:Leveraged firm

FIGURE 5-2Break-even chart:Conservative firm

TABLE 5-2Volume-cost-profit analysis:Leveraged firm

TABLE 5-3Volume-cost-profit analysis:Conservative firm

FIGURE 5-3Nonlinear break-evenanalysis

Operating Leverage

Measure of the amount of fixed operating costs used by a firm.

Degree of Operating Leverage (DOL) = % in EBIT (or Operating Income) / % in Sales

DOL = Q(P-VC) / (Q(P-VC) –FC)

Operating Leverage measures the sensitivity of a firm’s operating income to a in sales.

TABLE 5-4Operating income orloss

Financial Leverage

Measure of the amount of debt used by a firm

Degree of Financial Leverage (DFL) = % in EPS / % in EBIT (or Operating Income)

DFL = EBIT / (EBIT –I)

Financial Leverage measures the sensitivity of a firm’s earnings per share to a in operating income

Leverage Means Risk

Leverage is a double-edged swordIt magnifies profits as well as lossesAn aggressive or highly leveraged firm has

high fixed costs (and a relatively high break-even point)

A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point)

Many Japanese firms tend to be highly leveraged

FIGURE 5-4Financing plans andearnings per share

TABLE 5-5Impact of financingplan on earningsper share

Financial LeverageReflects the amount of debt used in the

capital structure of the firmDetermines how the operation is to be

financedDetermines the performance between two

firms having equal operating capabilities

BALANCE SHEET

Assets Liabilities and Net Worth

Operating leverage Financial leverage

TABLE 5-6Income statement

Combined or Total Leverage

Represents maximum use of leverage

Degree of Combined or Total Leverage (DCL or DTL) = % in EPS / % in Sales

DCL= Q(P-VC)/(Q(P-VC)-FC-I)= (S-TVC) /( S-TVC –FC- I)

Short-cut formula:DCL or DTL = DOL x DFL

TABLE 5-7Operating andfinancial leverage

Combining Operating and Financial LeverageCombined leverage: when both leverages

allow a firm to maximize returnsOperating leverage:

Affects the asset structure of the firmDetermines the return from operations

Financial leverage:Affects the debt-equity mixDetermines how the benefits received will be

allocated