operating and financial leverages_final
TRANSCRIPT
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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