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Meaning The ability to influence a system, or an environment, in a way that multiplies the outcome of one's efforts without a corresponding increase in the consumption of resources. In other words, leverage is the advantageous condition of having a relatively small amount of costyield a relatively high level of returns.
What is Leverage? Leverage is the use of fixed costs to magnify the potential return to a firm. Types of fixed costs: • fixed operating costs = rent, amortization of equipment and other long-lived assets. • fixed financial costs = interest costs from debt.
What is Leverage? • 3 types of leverage: -- Operating Leverage = the extent to which capital assets and associated fixed costs are utilized -- Financial Leverage = the amount of debt used in the capital structure (debt/equity mix) --Composite Leverage = the entire income of the concern.
Operating Leverage • One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Operating Leverage -- The use of fixed operating costs by the firm.
Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales 10 11 19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit1 2 2.5 FC/total costs .78 .22 .82 FC/sales .70 .18 .72 (in thousands)
Impact of Operating Leverage on Profits • Now, subject each firm to a 50% increase in sales for next year. • Which firm do you think will be more “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? [ ] Firm F; [ ] Firm V; [ ] Firm 2F.
Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales 15 16.5 29.25 Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5 Operating Profit5 4 10.75 Percentage Change 400% 100% 330% in EBIT* (in thousands) * (EBITt - EBIT t-1) / EBIT t-1
Impact of Operating Leverage on Profits • Firm F is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT. • Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. • Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage.
Break-Even Analysis • When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments. Break-Even Analysis -- A technique for studying the relationship among fixed costs, variable costs, sales volume, and profits. Also called cost/volume/profit (C/V/P) analysis.
Break-Even Chart QUANTITY PRODUCED AND SOLD Total Revenues Profits 250 Total Costs 175 REVENUES AND COSTS ($ thousands) Fixed Costs 100 Losses Variable Costs 50 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000
Break-Even (Quantity) Point Break-Even Point -- The sales volume required so that total revenues and total costs are equal; may be in units or in sales dollars. How to find the quantity break-even point: EBIT = P(Q) - V(Q) - FC EBIT = Q(P - V) - FC P = Price per unitV = Variable costs per unit FC = Fixed costs Q = Quantity (units) produced and sold
Degree of Operating Leverage (DOL) DOL at Q units of output (or sales) Degree of Operating Leverage -- The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent change in output (sales). Percentage change in operating profit (EBIT) = Percentage change in output (or sales)
Computing the DOL DOLQ units Calculating the DOL for a single product or a single-product firm. Q (P - V) = Q (P - V) - FC Q = Q - QBE
Computing the DOL DOLS dollars of sales Calculating the DOL for a multiproduct firm. S - VC = S - VC - FC EBIT + FC = EBIT
Financial Leverage • Financial leverage is acquired by choice. • Used as a means of increasing the return to common shareholders. Financial Leverage -- The use of fixed financing costs by the firm. The British expression is gearing.
EBIT-EPS Break-Even, or Indifference, Analysis EBIT-EPS Break-Even Analysis -- Analysis of the effect of financing alternatives on earnings per share. The break-even point is the EBIT level where EPS is the same for two (or more) alternatives. Calculate EPS for a given level of EBIT at a given financing structure. (EBIT - I) (1 - t) - Pref. Div. EPS = # of Common Shares
Financial Leverage • Financial leverage is acquired by choice. • Used as a means of increasing the return to common shareholders. Financial Leverage -- The use of fixed financing costs by the firm. The British expression is gearing.
Impact of Financial Leverage • A firm is considering two plans with a view to examining their impact on earnings per share (EPS) the total funds required in assets are Rs 5,00,000. Financial plans Debt (Interest @ 10% p.a) 4,00,000 1,00,000 Equity Shares(Rs 10 each) 1,oo,ooo 4,00,000 Total Finances required 5,oo,000 5,00,000 No. of equity shares 10,000 40,000 The earnings before interest and tax are assumed as Rs. 50,000 , Rs. 75,000 , Rs. 1,25,000 . The rate of tax be taken at 50% .
(1) When earnings before interest and tax (EBIT) are Rs. 50,000
(2) When earnings before interest and tax (EBIT) are Rs. 75,000
(3) When earnings before interest and tax (EBIT) are Rs. 1,25,000
Impact of Financial Leverage • The financial leverage is used to magnify the shareholders earnings. It us based on the assumption that the fixed charges or cost funds can be obtained at a cost lower than the firm’s rate of return on its assets . • When the difference between the assets financed by fixed cost funds and the cost of these funds are distributed to the equity stockholders , they will get additional earnings without increasing their own investment . • Consequently , the Earning per share (EPS) and the rate of return on equity share capital will go up . • The situation in which Earning per share (EPS) and the rate of return on equity share capital will go up , may also be reverse sometimes. • if the firm acquires fixed cost funds at a higher cost than the Earnings from those assets .
Degree of Financial Leverage (DFL) DFL at EBIT of X dollars Degree of Financial Leverage -- The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in operating profit. Percentage change in earnings per share (EPS) = Percentage change in operating profit (EBIT)
Computing the DFL DFL EBIT of $X Calculating the DFL EBIT = EBIT - I - [ PD / (1 - t) ] EBIT = Earnings before interest and taxes I = Interest PD = Preferred dividends t = Corporate tax rate
Variability of EPS DFLEquity = 1.00 DFLDebt = 1.25 DFLPreferred =1.35 Which financing method will have the greatest relative variability in EPS? • Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL. • This is due to the tax deductibility of interest on debt financing.
Importance of financial leverage • PLANNING OF CAPITAL STRUCTURE : A financial manager has to decide about the ratio between fixed costs funds and equity share capital. • PROFIT PLANNING: EPS is effected by degree of financial leverage . If the profitability of the concern is increasing than fixed costs funds will help in increasing the availability of profits for the equity stockholders . Therefore , financial leverage is important for profit planning .
Limitations of financial leverage • DOUBLE- EDGED WEAPON . • BENEICIAL ONLY TO COMPANIES HAVING STABILITY OF EARNINGS . • INCREASES RISK AND RATE OF RETURN . • RESTRICTIONS FROM FINANCIAL INSTITUIONS .
Composite Leverage Both financial and operating leverage magnify the revenue of the firm. Operating leverage affects the income which is result of production. On the other hand, the financial leverage is the result of financial decisions. The composite leverage focuses attention on the entire income of the concern. The risk factor should be properly assessed by the management before using the composite leverage. The high financial leverage may be offset against low operating leverage or vice-versa.
Degree of Composite leverage (DCL). The degree of composite leverage can be calculated as follows: Degree of composite leverage (DCL) = Percentage change in EPS Percentage Change in Sales Or, Composite leverage = Operating leverage * Financial leverage
Financial Risk Financial Risk -- The added variability in earnings per share (EPS) -- plus the risk of possible insolvency -- that is induced by the use of financial leverage. • Debt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100,000 to cover the interest payment. • Debt also increased the variability in EPS as the DFL increased from 1.00 to 1.25.
Total Firm Risk Total Firm Risk -- The variability in earnings per share (EPS). It is the sum of business plus financial risk. • CVEPS is a measure of relative total firm risk • CVEBIT is a measure of relative business risk • The difference, CVEPS - CVEBIT, is a measure of relative financial risk • Total firm risk = business risk + financial risk
Degree of Total Leverage (DTL) DTL at Q units (or S dollars) of output (or sales) Degree of Total Leverage -- The percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in output (sales). Percentage change in earnings per share (EPS) = Percentage change in output (or sales)
Computing the DTL DTL S dollars of sales DTL Q units (or S dollars) = ( DOL Q units (or S dollars) ) x ( DFL EBIT of X dollars ) EBIT + FC = EBIT - I - [ PD / (1 - t) ] Q (P- V) DTL Q units = Q (P- V) - FC - I - [ PD / (1 - t) ]
Summary and Conclusions • Leverage refers to the use of fixed costs to magnify the profits (or losses) of a firm. • Management must be aware of the level of risk assumed. • Operating leverage refers to using fixed operating costs, such as lease or amortization expense. Asset side related. • Financial leverage refers to the fixed financing charge such as interest cost on debt. Liability side related. • Composite leverage refers to the combination of both financial and operating leverage.
