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Chapter 5

Chapter 5. Operating and Financial Leverage. Chapter 5 - Outline . What is Leverage? Break-Even (BE) Point Operating Leverage Financial Leverage Leverage Means Risk Combined or Total Leverage. What is Leverage?.

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Chapter 5

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  1. Chapter 5 Operating and FinancialLeverage

  2. Chapter 5 - Outline • What is Leverage? • Break-Even (BE) Point • Operating Leverage • Financial Leverage • Leverage Means Risk • Combined or Total Leverage

  3. 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

  4. Leverage in a Business • Determining type of fixed operational costs • Plant and equipment • Can reduce expensive labor in production of inventory • Expensive labor • Lessens opportunity for profit but reduces risk exposure • Determining type of fixed financial costs • Debt financing • Can produce substantial profits, but failure to meet contractual obligations can result in bankruptcy • Selling equity • May reduce potential profits for existing shareholders, but reduces their risk exposure

  5. Break-Even (BE) Point • Quantity where Total Revenue equals Total Cost • Company has no Profit or Loss • BE = FC / (P – VC) • A leveraged firm has a high BE point • A non-leveraged firm has a low BE point

  6. FIGURE 5-1 Break-even chart:Leveraged firm

  7. FIGURE 5-2 Break-even chart:Conservative firm

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

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

  10. FIGURE 5-3 Nonlinear break-evenanalysis

  11. 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.

  12. TABLE 5-4 Operating income orloss

  13. 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

  14. Leverage Means Risk • Leverage is a double-edged sword • It magnifies profits as well as losses • An 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

  15. FIGURE 5-4 Financing plans andearnings per share

  16. TABLE 5-5 Impact of financingplan on earningsper share

  17. 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

  18. TABLE 5-6 Income statement

  19. 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

  20. TABLE 5-7 Operating andfinancial leverage

  21. 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

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