© 2003 McGraw-Hill Ryerson Limited 5 5 Chapter Operating and Financial Leverage McGraw-Hill Ryerson©2003 McGraw-Hill Ryerson Limited Prepared by: Terry Fegarty Seneca College Revised By P Chua

© 2003 McGraw-Hill Ryerson Limited Chapter 5 - Outline  What is Leverage?  Break-even Analysis  Operating Leverage  Financial Leverage  Combined or Total Leverage  Summary and Conclusions PPT 5-2

© 2003 McGraw-Hill Ryerson Limited What is Leverage?  In general terms, leverage means the use of force and effects to produce a more than normal results from a given action  In other words, leverage is the advantage generated by using a lever  Example, using a jack to lift a car  In Finance, leverage is the use of fixed costs to magnify the potential return to a firm  2 types of fixed costs:  fixed operating costs = rent, salaries, etc.  fixed financial costs = interest costs from debt PPT 5-3

© 2003 McGraw-Hill Ryerson Limited What is Leverage?  Leverage can magnify returns to common stockholders but can also increase risk  Management has almost complete control over this risk introduced through the use of leverage (fixed costs)  The degree in the use of leverage depends on management’s attitude toward risk and the nature of its business, among others.  Three types of leverage with reference to the firm’s income statement:  Operating leverage,  Financial leverage, and  Combined (Total) leverage.  Leverage is measured on the profitability range of operations.

© 2003 McGraw-Hill Ryerson Limited What is Leverage? Sales Less: Cost of Goods Sold Gross Margin Less: Operating Expenses Earnings Before Interest and Taxes (EBIT) Less: Interest Earnings Before Taxes Less: Taxes Earnings After Taxes (EAT) Number of Shares Outstanding Earnings Per Share Operating leverage Financial leverage

© 2003 McGraw-Hill Ryerson Limited What is Leverage? Sales Less: Total variable Costs Contribution Margin Less: Fixed Cost Earnings Before Interest and Taxes (EBIT) Less: Interest Earnings Before Taxes Less: Taxes Earnings After Taxes (EAT) Number of Shares Outstanding Earnings Per Share Operating leverage Financial leverage

© 2003 McGraw-Hill Ryerson Limited Breakeven Analysis  Break-even Analysis is used by the firm:  To determine the level of operations necessary to cover all operating costs, and  To evaluate the profitability associated with various levels of sales.  The Operating Breakeven Point is the level of sales necessary to cover all operating costs.  The formula for determining operating breakeven is: EBIT = (P  Q) – (VC  Q) – FC (1) where P = sales price per unit Q = sales quantity in units FC = fixed operating cost per period VC = variable operating cost per unit EBIT = earnings before interest and taxes

© 2003 McGraw-Hill Ryerson Limited Breakeven Quantity  Equation (1) can be rewritten to solve for the sales quantity that will breakeven: (2)  Since P – VC is the Contribution Margin per unit (CM/unit), equation 2 becomes: (3)

© 2003 McGraw-Hill Ryerson Limited Breakeven Analysis Plan A (Leveraged)Plan B (Less Leveraged- Conservative) Selling Price (/unit) = $2.00 Fixed Cost = $60,000Fixed Cost = $12,000 Variable Cost (/unit) = $0.80Variable Cost (/unit) = $1.60 Contribution Margin(/unit) = $1.20Contribution Margin(/unit) = $0.40 Break-Even Point (units) = 50,000Break-Even Point (units) = 30,000

© 2003 McGraw-Hill Ryerson Limited PPT 5-4 Figure 5-1 Break-even chart: leveraged firm Revenues and costs ($ thousands) Total Revenue Total costs Variable costs Fixed costs Profit BE Loss Units produced and sold (thousands) Price ($2) Variable costs per unit ($0.80) Fixed costs ($60,000)

© 2003 McGraw-Hill Ryerson Limited Table 5-2 Volume-cost-profit analysis: Leveraged firm TotalOperating Units VariableFixedTotalTotalIncome Sold CostsCosts Costs Revenue(loss) 00$60,000$ 60,000 0$(60,000) 20,000 16,000 60,000 76,000$ 40,000(36,000) 40,00032,00060,000 92,000 80,000(12,000) 50,00040,00060,000100,000100, ,00048,00060,000108,000120,000 12,000 80,00064,00060,000124,000160,000 36, ,00080,00060,000140,000200,000 60,000 PPT 5-5

© 2003 McGraw-Hill Ryerson Limited PPT 5-6 Figure 5-2 Break-even chart: conservative firm Revenues and costs ($ thousands) Total Revenue Total costs Variable costs Fixed costs Profit BE Loss Units produced and sold (thousands) Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)

© 2003 McGraw-Hill Ryerson Limited Table 5-3 Volume-cost-profit analysis: Less Leveraged (Conservative) firm 00 $12,000 $12,000 0$(12,000. ) 20,000$ 32,00012,000 44,000$ 40,000 (4,000. ) 30,000 48,00012,000 60,000 60, ,000 64,00012,000 76,000 80,000 4,000 60,000 96,00012,000108,000120,00012,000 80,000128,00012,000140,000160,00020, ,000160,00012,000172,000200,00028,000 Total Operating UnitsVariable FixedTotalTotal Income SoldCostsCosts Costs Revenue (loss) PPT 5-7

© 2003 McGraw-Hill Ryerson Limited 0$(60,000)$(12,000) 20,000(36,000)(4,000) 30,000 (12,000) 0 40,000(12,000)4,000 50, ,000 60,00012,000 12,000 80,00036,000 20, ,00060,000 28,000 Leveraged Less Leveraged Plan (Conservative) Plan Units EBIT EBIT PPT 5-10 Table 5-4 Operating income or loss

© 2003 McGraw-Hill Ryerson Limited Leverage Means Risk  Leverage is a double-edged sword It magnifies losses as well as profits  An aggressive or highly leveraged firm has a relatively high break-even point (and high fixed costs)  A conservative or less-leveraged firm has a relatively low break-even point (and low fixed costs) PPT 5-8

© 2003 McGraw-Hill Ryerson Limited Operating Leverage  Measures the amount of fixed operating costs used by a firm  Operating Leverage measures the sensitivity of a firm’s operating income to a  in sales  a  in Sales  a larger  in EBIT (or OI) Degree of Operating Leverage (DOL)= %age  in EBIT ( or OI) %age  in Sales PPT 5-9

© 2003 McGraw-Hill Ryerson Limited Calculating the Degree of Operating Leverage  DOL can be computed using the following formula:or

© 2003 McGraw-Hill Ryerson Limited Financial Leverage  Measure of the amount of debt used and interest paid by a firm  Financial Leverage measures the sensitivity of a firm’s earnings per share to a  in operating income  a  in EBIT (or OI)  a larger  in EPS Degree of Financial Leverage (DFL) = %age  in EPS %age  in EBIT (or OI) PPT 5-12

© 2003 McGraw-Hill Ryerson Limited Calculating the Degree of Financial Leverage  DFL can be computed using the following formula:

© 2003 McGraw-Hill Ryerson Limited Financing Plans Total Assets = $200,000 Plan A (Leveraged)Plan B (Less Leveraged- Conservative) Debt (8%)$150,000 ($12,000 interest) $50,000 ($4,000 interest) Common Stock$50,000 (8,000 $6.25) $150,000 (24,000 $6.25) Total Financing$200,000

© 2003 McGraw-Hill Ryerson Limited 1.EBIT (0) Earnings before interest and taxes (EBIT)00 — Interest (I)$(12,000.)$ (4,000.) Earnings before taxes (EBT)(12,000.)(4,000.) — Taxes (T) *(6,000.)(2,000.) Earnings aftertaxes(EAT)$ (6,000.)$ (2,000.) Shares8,00024,000 Earnings per share (EPS) $ (0.75) $ (0.08) 2.EBIT ($12,000) Earnings before interest and taxes (EBIT)$12,000$12,000 — Interest (I)12,0004,000 Earnings before taxes (EBT)08,000 — Taxes (T)04,000 Earnings aftertaxes (EAT)$ 0$ 4,000 Shares8,00024,000 Earnings per share (EPS) 0 $0.17 Plan APlan B (leveraged)(conservative) * The assumption is that large losses can be written off against other income, perhaps in other years, thus providing the firm with a tax savings benefit. The tax rate is 50 percent. PPT 5-13 Table 5-5a Impact of financing plan on earnings per share

© 2003 McGraw-Hill Ryerson Limited 3.EBIT ($16,000) Earnings before interest and taxes (EBIT)$ 16,000$ 16,000 — Interest (I) 12,0004,000 Earnings before taxes (EBT)4,00012,000 — Taxes (T) 2,0006,000 Earnings aftertaxes (EAT)$ 2,000$ 6,000 Shares8,00024,000 Earnings per share (EPS)$0.25$ EBIT ($36,000) Earnings before interest and taxes (EBIT)$ 36,000$ 36,000 — Interest (I)12,0004,000 Earnings before taxes (EBT)24,00032,000 — Taxes (T)12,00016,000 Earnings aftertaxes (EAT)$ 12,000$ 16,000 Shares8,00024,000 Earnings per share (EPS)$1.50$0.67 Plan APlan B (leveraged)(conservative) PPT 5-14 Table 5-5b Impact of financing plan on earnings per share

© 2003 McGraw-Hill Ryerson Limited 5.EBIT ($60,000) Earnings before interest and taxes (EBIT)$ 60,000$ 60,000 — Interest (I) 12,0004,000 Earnings before taxes (EBT)48,00056,000 — Taxes (T) 24,00028,000 Earnings aftertaxes (EAT)$ 24,000$ 28,000 Shares8,00024,000 Earnings per share (EPS)$3.00$ 1.17 Plan APlan B (leveraged)(conservative) PPT 5-15 Table 5-5c Impact of financing plan on earnings per share

© 2003 McGraw-Hill Ryerson Limited 0 $ (0.75) $ (0.08) 12,000 0 $ ,000 $0.25 $ ,000 $1.50 $ ,000 $3.00 $ 1.17 Leveraged Less Leveraged Plan (Conservative) Plan EBIT EPS EPS PPT 5-10 EBIT and EPS under both plans

© 2003 McGraw-Hill Ryerson Limited PPT 5-16 Figure 5-4 Financing plans and earnings per share EBIT ($ thousands) EPS ($) Plan A Plan B

© 2003 McGraw-Hill Ryerson Limited Combined or Total Leverage  Represents maximum use of leverage  a  in Sales  a larger  in EPS Degree of Combined Leverage (DCL ) = %age  in EPS %age  in Sales Short-cut formula: DCL = DOL x DFL PPT 5-19

© 2003 McGraw-Hill Ryerson Limited Calculating the Degree of Combined Leverage  DCL can be computed using the following formula: OR

© 2003 McGraw-Hill Ryerson Limited Sales (80,000 $2) $160,000 Less: Variable costs ($0.80 per unit) 64,000 Contribution Margin 96,000 Less: Fixed costs60,000 Earnings before interest and taxes$ 36,000 Less:Interest12,000 Earnings before taxes24,000 Less:Taxes12,000 Earnings aftertaxes$ 12,000 Shares8,000 Earnings per share$1.50 Operating Leverage = 2.67 Financial Leverage = 1.5 Combined Leverage= 4 PPT 5-18 Operating, Financial and Combined Leverage under Leveraged Plan

© 2003 McGraw-Hill Ryerson Limited Sales (80,000 $2) $160,000 Less: Variable costs ($1.60 per unit) 128,000 Contribution Margin 32,000 Less: Fixed costs12,000 Earnings before interest and taxes$ 20,000 Less:Interest4,000 Earnings before taxes16,000 Less:Taxes8,000 Earnings aftertaxes$ 8,000 Shares24,000 Earnings per share$0.33 Operating Leverage = 1.6 Financial Leverage = 1.25 Combined Leverage= 2 PPT 5-18 Operating, Financial and Combined Leverage under Less Leveraged (Conservative) Plan

© 2003 McGraw-Hill Ryerson Limited Calculating EBIT at Indifference Point  Level of EBIT where the firm’s EPS are equal between 2 financing plans  This is computed using the following formula: Where: EBIT is the operating income at the indifference point I is the interest cost under plan A and B S is shares outstanding under plan A and B

© 2003 McGraw-Hill Ryerson Limited Summary and Conclusions  Leverage uses fixed costs to magnify the profits (or losses) of a business  Operating leverage refers to fixed operating costs, such as lease or amortization expense  The degree of operating leverage (DOL) measures the %age change in operating income from a %age change in sales  Financial leverage refers to interest expense on debt  The degree of financial leverage (DFL) measures the %age change in earnings from a %age change in operating income  The higher the level of fixed costs, the greater the effect on net income of an increase in sales revenue (This is the degree of combined leverage (DCL)) PPT 5-22