1 of 29 ©2012 McGraw-Hill Ryerson Limited Learning Objectives 1.Calculate break-even in units and in dollars. (LO1) 2.Define leverage as a method to magnify earnings available to the firm’s common shareholders. (LO2) 3.Define and calculate operating leverage and assess its opportunities and limitations. (LO3)

2 of 29 ©2012 McGraw-Hill Ryerson Limited What is Leverage? Leverage is using fixed costs to magnify the potential return to a firm 2 types of fixed costs: 1.fixed operating costs = rent, amortization 2.fixed financial costs = interest costs from debt LO2

3 of 29 ©2012 McGraw-Hill Ryerson Limited Sales (total revenue) (80,000 $2) $160,000 — Variable costs ($0.80 per unit)64,000 Contribution margin 96,000 — Fixed costs60,000 Operating income 36,000 Earnings before interest and taxes 36,000 — Interest Expense12,000 Earnings before taxes24,000 — Taxes12,000 Earnings after taxes$ 12,000 Shares8,000 Earnings per share$1.50 Operating leverage Financial leverage Table 5-1 Income statement LO2

4 of 29 ©2012 McGraw-Hill Ryerson Limited Break-Even Analysis Break-even analysis is the technique used to study the effect of sales volume on costs and profit. The interesting sales volume is the break-even (BE) sales level, at which a firm’s total revenue equals total cost, that is, the firm does not make money nor lose money (breaks even) Mathematically, LO2

5 of 29 ©2012 McGraw-Hill Ryerson Limited Table 5-3 Volume-cost-profit analysis: leveraged firm 00 60,000 $60,000 0$(60,000) 20,000$ 16,00060,000 76,000$ 40,000 (36,000) 40,000 32,00060,000 92,000 80,000(12,000) 50,000 40,00060, , , ,000 48,00060,000108,000120,00012,000 80,00064,00060,000124,000160,00036, ,00080,00060,000140,000200,00060,000 Total Operating UnitsVariable FixedTotalTotal Income SoldCostsCosts Costs Revenue (loss) LO2

6 of 29 ©2012 McGraw-Hill Ryerson Limited Figure 5-1 Break-even chart In dollars and units: leveraged firm LO2

7 of 29 ©2012 McGraw-Hill Ryerson Limited Table 5-4 Volume-cost-profit analysis: 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) LO2

8 of 29 ©2012 McGraw-Hill Ryerson Limited Figure 5-2 Break-even chart: conservative firm (low risk) LO2

9 of 29 ©2012 McGraw-Hill Ryerson Limited Operating Leverage Measures the amount of fixed operating costs used by a firm Degree of Operating Leverage (DOL)= Percent change in operating income Percent change in unit volume a  in Sales  a larger  in Operating Income (or EBIT) if DOL > 1 DOL measures the sensitivity of a firm’s operating income to a  in sales LO2

10 of 29 ©2012 McGraw-Hill Ryerson Limited Risk Analysis of Leverage A leveraged firm has high fixed costs, a high BE point and high DOL. A non-leveraged firm has low fixed costs, a low BE point and low DOL. Leverage is a double-edged sword. It magnifies losses as well as profits. LO2

11 of 29 ©2012 McGraw-Hill Ryerson Limited Formula Review LO2/LO3/LO4 DCL = DOL × DFL