leverage by alicejenny

VIEWS: 8 PAGES: 39

									Analysis and Impact
   of Leverage?
   Two concepts that enhance
   our understanding of risk...

1) Operating Leverage - affects a
  firm’s business risk.

2) Financial Leverage - affects a
  firm’s financial risk.
          Business Risk
 The variability or uncertainty of a
 firm’s operating income (EBIT).


                               Stock-
EBIT     FIRM         EPS      holders
     Business Risk
Affected by:
 Sales volume variability
 Competition
 Product diversification
 Operating leverage
 Growth prospects
 Size
          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.


    EBIT

                               Operating
                               Leverage
         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.

                               Stock-
EBIT     FIRM         EPS      holders
      Financial Leverage
 The use of fixed-cost sources of
 financing (debt, preferred stock)
 rather than variable-cost sources
 (common stock).

  EPS


                          Financial
                          Leverage
      Breakeven Analysis

 Illustrates the effects of operating
  leverage.
 Useful for forecasting the
  profitability of a firm, division, or
  product line.
 Useful for analyzing the impact of
  changes in fixed costs, variable
  costs, and sales price.
                  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).
       $                Total Revenue

                          Total Cost




  FC   {
                          Quantity
                           Total Revenue

 $                             Total Cost
                           } EBIT
                      +



     -
FC {
         Break-even       Q1   Quantity
            point
                                         Total Revenue
      If the firm increases its fixed
 $       operating costs and reduces
         (or eliminates) its variable
         costs …
                                    +    }   EBIT


 {
FC       -
                                              Total Cost
                                              = Fixed

                                                  Qty
                 Break-even             Q1
                    point
 Operating Leverage
With high operating leverage,
     an increase in sales
 produces a relatively larger
    increase in operating
           income.
     Trade-off:
                                         Total Revenue
     the firm has a higher
 $   breakeven point. If sales
     are not high enough, the
     firm will not meet its fixed
     expenses!
                                    +    }   EBIT

                                              Total Cost
 {
FC   -                                        = Fixed

                                                  Qty
                  Break-                Q1
                   even
                   point
   Breakeven Calculations
Breakeven point (units of output)

                 F
       QB =
                P-V
 QB = breakeven level of Q.
 F = total anticipated fixed costs.
 P = sales price per unit.
 V = variable cost per unit.
  Breakeven Calculations
Breakeven point (sales dollars)
                  F
    S* =       1-
                   VC
                    S
 S* = breakeven level of sales.
 F = total anticipated fixed costs.
 S = total sales.
 VC = total variable costs.
      Analytical Income Statement

    sales
-   variable costs
-   fixed costs
    operating income
-   interest
    EBT
-   taxes
    net income
        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.
Degree of Operating Leverage
      from Sales Level (S)


 DOLs =      % change in EBIT
             % change in sales

                change in EBIT
                    EBIT
        =
                change in sales
                    sales
    Degree of Operating Leverage
              from Sales Level (S)
 If we have the data, we can use this formula:



          Sales - Variable Costs
   DOLs =
                  EBIT

                     Q(P - V)
             =
                    Q(P - V) - F
    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-
   Sales    EBIT         EPS       holders
       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.
Degree of Financial Leverage

   DFL =       % change in EPS
               % change in EBIT

                change in EPS
                    EPS
           =
                change in EBIT
                    EBIT
Degree of Financial Leverage
 If we have the data, we can use this
  formula:


        DFL =  EBIT
              EBIT - I
     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-
   Sales    EBIT         EPS     holders
          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.
Degree of Combined Leverage

   DCL = DOL x DFL

          % change in EPS
        =
          % change in Sales

            change in EPS
                EPS
        =
            change in Sales
                Sales
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
     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-
   Sales     EBIT         EPS      holders
        In-class Project:
Based on the following information on
 Levered Company, answer these
 questions:

1) If sales increase by 10%, what should
  happen to operating income?
2) If operating income increases by 10%,
  what should happen to EPS?
3) If sales increase by 10%, what should be
  the effect on EPS?
          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
          Levered Company




               Operating
Sales           Income
                                   EPS


        Operating      Financial
         leverage      leverage
Degree of Operating Leverage
       from Sales Level (S)



       Sales - Variable Costs
DOLs =
               EBIT

           1,400,000 - 800,000
     =
                350,000


          = 1.714
        Levered Company




           Operating
Sales       Income
                          EPS
          Levered Company

                    17.14%
 10%

               Operating
Sales           Income
                             EPS


        Operating
         leverage
Degree of Financial Leverage


    DFL =  EBIT
          EBIT - I

        =    350,000
             225,000

            = 1.556
        Levered Company

                                15.56%
              10%

           Operating
Sales       Income
                                EPS


                    Financial
                    leverage
Degree of Combined Leverage


DCL =      Sales - Variable Costs
                  EBIT - I

     =     1,400,000 - 800,000
                 225,000


         = 2.667
         Levered Company

                                   26.67%
10%

               Operating
Sales           Income
                                   EPS


        Operating      Financial
         leverage      leverage
           Levered Company
            10% increase in sales
Sales (110,000 units)      1,540,000
Variable Costs             (880,000)
Fixed Costs                (250,000)
EBIT                        410,000 ( +17.14%)
Interest                   (125,000)
EBT                         285,000
Taxes (34%)                 (96,900)
Net Income                  188,100
EPS                          $1.881 ( +26.67%)

								
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