Leverage and Capital Structure-Part 1 Chapter 7 Leverage and Capital Structure-Part 1

Leverage Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return. The amount of leverage in the firm’s capital structure— the mix of debt and equity—can significantly affect its value by affecting risk and return. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

3 basis types of leverage Operating leverage-concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes. Financial Leverage-concerned with the relationship between the firm’s EBIT and its earnings per share Total leverage-concerned with the relationship between the firm’s sales revenue and EPS. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Leverage (cont.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Breakeven Analysis Breakeven (cost-volume-profit) analysis is used by the firm to: determine the level of operations necessary to cover all operating costs, and evaluate the profitability associated with various levels of sales. The firm’s operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses. At the OBP, operating profit (EBIT) is equal to zero. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Breakeven Analysis (cont.) To calculate the OBP, cost of goods sold and operating expenses must be categorized as fixed or variable. Variable costs vary directly with the level of sales and are a function of volume, not time. Examples would include direct labor and shipping costs. Fixed costs are a function of time and do not vary with sales volume. Examples would include rent and fixed overhead. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Breakeven quantity= FC P-VC Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

OPERATING LEVERAGE Operating leverage results from the existence of fixed operating costs in the firm’s income stream. Operating leverage can be defined as the potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Operating Leverage (cont.) Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Operating Leverage: Measuring the Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales. A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL. Only companies that use fixed costs in the production process will experience operating leverage. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Operating Leverage: Measuring the Degree of Operating Leverage (cont) DOL = Percentage change in EBIT Percentage change in Sales Applying this equation to cases 1 and 2 in Table 12.4 yields: Case 1: DOL = (+100% ÷ +50%) = 2.0 Case 2: DOL = (-100% ÷ -50%) = 2.0 Copyright © 2006 Pearson Addison-Wesley. All rights reserved.