Operating Leverage Financial Leverage - PowerPoint PPT Presentation

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Operating Leverage Financial Leverage

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  1. Ch. 15: Analysis and Impact of Leverage • Operating Leverage • Financial Leverage  2002, Prentice Hall, Inc.

  2. What is Leverage?

  3. What is Leverage?

  4. What is Leverage?

  5. 2 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.

  6. Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  7. EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  8. FIRM EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  9. FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  10. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  11. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

  12. Business Risk Affected by: • Sales volume variability • Competition • Cost variability • Product diversification • Product demand • Operating Leverage

  13. 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.

  14. EBIT Operating Leverage

  15. 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.

  16. Stock- holders FIRM EPS EBIT 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.

  17. Stock- holders FIRM EPS EBIT 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.

  18. Financial Leverage • The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

  19. EPS Financial Leverage

  20. 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.

  21. $ Quantity Breakeven Analysis

  22. Total Revenue $ Quantity

  23. 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).

  24. Total Revenue $ Quantity

  25. Total Revenue Total Cost $ { FC Quantity

  26. Total Revenue Total Cost $ { FC Quantity } EBIT + - Q1

  27. Total Revenue Total Cost $ } EBIT + - { FC Q1 Quantity Break- even point

  28. Operating Leverage • What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

  29. Total Revenue Total Cost $ } EBIT + - { FC Q1 Quantity Break- even point

  30. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point

  31. With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

  32. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point

  33. Total Revenue } $ EBIT + { Total Cost = Fixed - FC Q1 Quantity Break- even point Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

  34. Breakeven Calculations

  35. F P - V QB = Breakeven Calculations Breakeven point (units of output)

  36. F P - V QB = Breakeven Calculations Breakeven point (units of output) • QB = breakeven level of Q. • F = total anticipated fixed costs. • P = sales price per unit. • V = variable cost per unit.

  37. F VC S S* = 1 - Breakeven Calculations Breakeven point (sales dollars)

  38. F VC S S* = 1 - Breakeven Calculations Breakeven point (sales dollars) • S* = breakeven level of sales. • F = total anticipated fixed costs. • S = total sales. • VC = total variable costs.

  39. Analytical Income Statement sales - variable costs - fixed costs operating income - interest EBT - taxes net income

  40. Analytical Income Statement } contribution margin sales - variable costs - fixed costs operating income - interest EBT - taxes net income

  41. Analytical Income Statement } contribution margin sales - variable costs - fixed costs operating income - interest EBT - taxes net income EBT (1 - t) = Net Income, so, Net Income / (1 - t) = EBT

  42. 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.

  43. Degree of Operating Leveragefrom Sales Level (S) % change in EBIT % change in sales DOLs =

  44. Degree of Operating Leveragefrom Sales Level (S) % change in EBIT % change in sales DOLs = change in EBIT EBIT change in sales sales =

  45. Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula:

  46. Sales - Variable Costs EBIT DOLs = Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula:

  47. Sales - Variable Costs EBIT DOLs = Q(P - V) Q(P - V) - F = Degree of Operating Leveragefrom Sales Level (S) • If we have the data, we can use this formula:

  48. What does this tell us? • If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).