Operating and Financial Leverage
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Presentation Transcript
Chapter Outline • What is leverage? • Operating leverage. • Financial leverage. • Potential profits or increased risk?
What is Leverage? • Use of special forces and effects to magnify or produce more than the normal results from a given course of action. • Can produce beneficial results in favorable conditions. • Can produce highly negative results in unfavorable conditions.
Leverage in Business • Determining type of fixed operational costs. • Plant and equipment • Eliminates labor in production of inventory. • Expensive labor • Lessens opportunity for profit but reduces risk exposure. • Determining type of fixed financial costs. • Debt financing • Substantial profits but failure to meet contractual obligations can result in bankruptcy. • Selling equity • Reduces potential profits but minimize risk exposure.
Operating Leverage • The extent to which fixed assets and associated fixed costs are utilized in a business. • Operational costs include: • Fixed • Variable • Semivariable
Break-Even Analysis • The break-even point is at 50,000 units, where the total costs and total revenue lines intersect. Units = 50,000 . Total Variable Fixed Costs Total Costs Total Revenue Operating Income Costs (TVC) (FC) (TC) (TR) (loss) (50,000 X $0.80) (50,000 X $2) $40,000 $60,000 $100,000 $100,000 0
Break-Even Analysis (cont’d) • The break-even point can also be calculated by: Fixed costs = Fixed costs = FC Contribution margin Price – Variable cost per unit P – VC i.e. $60,000 = $60,000 = 50,000 units $2.00 - $0.80 $1.20
A Conservative Approach • Some firms choose not to operate at high degrees of operating leverage. • More expensive variable costs may be substituted for automated plant and equipment. • This approach may cut into potential profitability of the firm as shown in Figure 5-2.
The Risk Factor • Factors influencing decision on maintaining a conservative or a leveraged stance include: • Economic condition. • Competitive position within industry. • Future position – stability versus market leadership. • Matching an acceptable return with a desired level of risk.
Cash Break-Even Analysis • Helps in analyzing the short-term outlook of a firm. • Non-cash items are excluded: • Depreciation • Sales (accounts receivable rather than cash) • Purchase of materials • Accounts payable
Degree of Operating Leverage (DOL) • Percentage change in operating income • Occurs as a result of a percentage change in units sold. • Computed only over a profitable range of operations. • Directly proportional to the firm’s break-even point. DOL = Percent change in operating income Percent change in unit volume
Computation of DOL • Leveraged firm: DOL = Percent change in operating income = $24,000 X 100 Percent change in unit volume $36,000 20,000 X 100 80,000 = 67% = 2.7 25% • Conservative firm: DOL = Percent change in operating income = $8,000 X 100 Percent change in nit volume $20,000 20,000 X 100 80,000 = 40% = 1.6 25%
Algebraic Formula for DOL DOL = Q (P – VC) Q (P – VC) – FC Where, • Q = Quantity at which DOL is computed. • P = Price per unit. • VC = Variable costs per unit. • FC = Fixed costs. • For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000: DOL = 80,000 ($2.00 - $0.80) ; 80,000 ($2.00 - $0.80) - $60,000 = 80,000 ($1.20) = $96,000 ; 80,000 ($1.20) - $60,000 $96,000 - $60,000 i.e. DOL = 2.7
Limitations of Analysis • Weakening of price in an attempt to capture an increasing market. • Cost overruns when moving beyond an optimum-size operation. • Relationships are not fixed.
Financial Leverage • Reflects the amount of debt used in the capital structure of the firm. • Determines how the operation is to be financed. • Determines the performance between two firms having equal operating capabilities. BALANCE SHEET Assets Liabilities and Net Worth Operating leverage Financial leverage
Impact on Earnings • Examine two financial plans for a firm, where $200,000 is required to carry the assets. Total Assets = $200,000 Plan A (leveraged) Plan B (conservative) Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest) Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25) Total financing $200,000 $200,000
Degree of Financial Leverage DFL = Percent change in EPS Percent change in EBIT • For the purpose of computation, it can be restated as: DFL = EBIT . EBIT – I • Plan A (Leveraged): DFL = EBIT = $36,000 = $36,000 = 1.5 EBIT – I $36,000 - $12,000 $24,000 • Plan B (Conservative): DFL = EBIT = $36,000 = $36,000 = 1.1 EBIT – I $36,000 - $4,000 $32,000
Limitations to the Use of Financial Leverage • Beyond a point, debt financing is detrimental to the firm. • Lenders will perceive a greater financial risk. • Common stockholders may drive down the price. • Recommended for firms that are: • In an industry that is generally stable. • In a positive stage of growth. • Operating in favorable economic conditions.
Combining Operating and Financial Leverage • Combined leverage: when both leverages allow a firm to maximize returns. • Operating leverage: • Affects the asset structure of the firm. • Determines the return from operations. • Financial leverage: • Affects the debt-equity mix. • Determines how the benefits received will be allocated.
Degree of Combined Leverage • Uses the entire income statement. • Shows the impact of a change in sales or volume on bottom-line earnings per share. DCL = Percentage change in EPS ; Percentage change in sales (or volume) • Using data from Table 5-7: Percent change in EPS = $1.50 X 100 Percent change in sales $1.50 = 100% = 4 $40,000 X 100 $25% $160,000
Degree of Combined Leverage (cont’d) DCL = Q (P – VC) , Q (P – VC) – FC – I From Table 5-7, • Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000. DCL = 80,000 ($2.00 - $0.80) = 80,000 ($2.00 - $0.80) - $60,000 - $12,000 = 80,000 ($1.20) = 80,000 ($1.20) - $72,000 DCL = $96,000 = $96,000 = 4 $96,000 - $72,000 $24,000
