Operating and Financial Leverage

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Chapter 5

• Operating and FinancialLeverage

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Chapter 5 - Outline

• What is Leverage?
• Break-Even (BE) Point
• Operating Leverage
• Financial Leverage
• Leverage Means Risk
• Combined or Total Leverage

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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

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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

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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

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FIGURE 5-1 Break-even chartLeveraged firm
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FIGURE 5-2 Break-even chartConservative firm
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TABLE 5-2 Volume-cost-profit analysisLeveraged
firm
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TABLE 5-3 Volume-cost-profit analysisConservativ
e firm
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FIGURE 5-3 Nonlinear break-evenanalysis
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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
  firms operating income to a ? in sales.

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TABLE 5-4 Operating income orloss
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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
  firms earnings per share to a ? in operating
  income

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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

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FIGURE 5-4 Financing plans andearnings per share
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TABLE 5-5 Impact of financingplan on
earningsper share
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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

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TABLE 5-6 Income statement
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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

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TABLE 5-7 Operating andfinancial leverage
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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