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

Leverage Analysis Operating Leverage Financial Leverage Affects a firm’s business risk Business risk is the variability or uncertainty of a firm’s operating income (EBIT) Financial Leverage Affects a firm’s financial risk Financial risk is 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

Illustrates the effects of operating leverage 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 Terms: P: price per unit, Q: quantity produced, V: variable costs per unit, VC; total variable costs, F; total fixed costs, TC: total cost (VC+F), S: sales ($)

Breakeven Analysis Quantity $ Total Revenue (PQ)

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)

} - { Breakeven Analysis + Q1 Total Revenue Total Cost $ (QV)+F or Quantity { $ Total Revenue Total Cost (QV)+F or VC+F FC } + EBIT - Q1 Breakeven EBIT

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

} { Breakeven Analysis Total Revenue $ EBIT + Total Cost = Fixed - FC With high operating leverage, an increase in sales produces a relatively larger increase in operating income. Quantity $ Total Revenue Total Cost = Fixed FC Q1 + - EBIT } Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses! { Breakeven EBIT

Breakeven Calculations – Quantity

Breakeven Calculations – Sales

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

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

Degree of Operating Leverage from Sales Level (S) Above calculation requires two analytical income statements, one for the base period and one for the following period using the new level of sales

Degree of Operating Leverage from Sales Level (S) If we have the base level data, we can use this formula: Implicit assumption is that Variable Costs / Sales and Fixed Costs stay the constant If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT) and vice versa %Δ in EBIT = DOLSales x %Δ in Sales

Degree of Financial Leverage (DFL) Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share (EPS) This “multiplier effect” is called the degree of financial leverage

Degree of Financial Leverage Each financing or capital structure (relative use of debt and equity) alternative will have a different degree of financial leverage (DFL)

Degree of Financial Leverage Instead of calculating DFL for each alternative capital structure we can use the following formula with the base EBIT and differing interest expenses Note that interest expense would be based on how much debt is used financing the assets of the firm If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share and vice versa %Δ in EPS = DFLEBIT x %Δ in EBIT

Degree of Combined Leverage (DCL) Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share This “multiplier effect” is called the degree of combined leverage

Degree of Combined Leverage

Degree of Combined Leverage If we have the base level data, we can use this formula: If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share %Δ in EPS = DCLSales x %Δ in Sales

Example Based on the following information on a Levered Company, answer these questions: 1) If sales increase by 10%, what should happen to operating income? 2) If operating income increases by 10%, what should happen to EPS? 3) If sales increase by 10%, what should be the effect on EPS?

Levered Company – Data Sales (100,000 units) $1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Shares outstanding 100,000

Leverage Sales EBIT EPS DOL DFL DCL

Levered Company – Base Level Data Sales (100,000 units) $1,400,000 Variable Costs ($800,000) Fixed Costs ($250,000) EBIT (Operating Income) $350,000) Interest paid ($125,000) EBT $225,000 Tax @ 34% ($75,500) EAT (Net Income) $148,500 EPS = $148,500 / 100,000 = $1.485

Degree of Operating Leverage from Sales Level (S) Answer to part 1: %Δ in EBIT = DOLSales x %Δ in Sales %Δ in EBIT = 1.714 x 10% = 17.14%

Degree of Financial Leverage Answer to part 2: %Δ in EPS = DFLEBIT x %Δ in EBIT %Δ in EPS = 1.556 x 10% = 15.56% %Δ in EPS = 1.556 x 17.14% = 26.67% (cumulative impact of part 1

Degree of Combined Leverage Answer to part 3: Alternatively DCL = DOL x DFL DCL = 1.714 x 1.556 = 2.667 %Δ in EPS = 2.667 x 10% = 26.67%

Levered Company Sales EBIT EPS DOL = 1.714 DFL = 1.556 DCL = 2.667

Levered Company 10% increase in sales Sales (110,000 units) 1,540,000 Variable Costs (880,000) Fixed Costs (250,000) EBIT 410,000 ( +17.14%) Interest (125,000) EBT 285,000 Taxes (34%) (96,900) Net Income 188,100 EPS $1.881 ( +26.67%)