©2009 McGraw-Hill Ryerson Limited 1 of 28 ©2009 McGraw-Hill Ryerson Limited 5 5 Operating and Financial Leverage Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 28 Chapter 5 - Outline What is Leverage? Break-Even Analysis Operating Leverage Risk Analysis of Leverage Financial Leverage Indifference Point Combined or Total Leverage Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 28 Learning Objectives 1.Define leverage as a method to magnify earnings available to the firm’s common shareholders. (LO1) 2.Define and calculate operating leverage and assess its opportunities and limitations. (LO2) 3.Define and calculate financial leverage and assess its opportunities and limitations. (LO3)

©2009 McGraw-Hill Ryerson Limited 4 of 28 Learning Objectives 4.Calculate the indifference point between financing plans using EBIT/EPS analysis. (LO4) 5.Define and calculate combined leverage. (LO5)

©2009 McGraw-Hill Ryerson Limited 5 of 28 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 LO1

©2009 McGraw-Hill Ryerson Limited 6 of 28 What is Leverage? 2 types of leverage: 1.Operating Leverage = the extent to which capital assets and associated fixed costs are utilized 2.Financial Leverage = the amount of debt used in the capital structure (debt/equity mix) LO1

©2009 McGraw-Hill Ryerson Limited 7 of 28 Sales (total revenue) (80,000 $2)$160,000 — Variable costs ($0.80 per unit)64,000 Contribution margin 96,000 — Fixed costs60,000 Operating income 36,000 Earnings before interest and taxes 36,000 — Interest Expense12,000 Earnings before taxes24,000 — Taxes12,000 Earnings aftertaxes$ 12,000 Shares8,000 Earnings per share$1.50 Operating leverage Financial leverage Table 5-1 Income statement LO1

©2009 McGraw-Hill Ryerson Limited 8 of 28 Break-Even Analysis A firm’s operational costs may be classified as: -- fixed: those costs that remain the same in the short run (e.g.: rental, amortization, executive salaries, property taxes) -- variable: those costs that change as production/sales changes (e.g. raw material, factory labour, sales commissions) -- semi variable: those costs that may change but not directly related to production/sales (e.g. utilities, repairs and maintenance) LO1

©2009 McGraw-Hill Ryerson Limited 9 of 28 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

©2009 McGraw-Hill Ryerson Limited 10 of 28 Table 5-3 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 LO2

©2009 McGraw-Hill Ryerson Limited 11 of 28 FIGURE 5-1 Break-even chart: Leveraged firm LO2

©2009 McGraw-Hill Ryerson Limited 12 of 28 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

©2009 McGraw-Hill Ryerson Limited 13 of 28 FIGURE 5-2 Break-even chart: Conservative firm LO2

©2009 McGraw-Hill Ryerson Limited 14 of 28 Operating Leverage Measures the amount of fixed operating costs used by a firm Degree of Operating Leverage (DOL)= %age  in EBIT ( or OI) %age  in Sales a  in Sales  a larger  in EBIT (or OI) if DOL > 1 DOL measures the sensitivity of a firm’s operating income to a  in sales LO2

©2009 McGraw-Hill Ryerson Limited 15 of 28 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

©2009 McGraw-Hill Ryerson Limited 16 of 28 0$(60,000)$(12,000) 20,000(36,000)(4,000) 40,000(12,000)4,000 60,00012,000 12,000 80,00036,000 20, ,00060,000 28, Leveraged Conservative Firm Firm Units (Table 5-3) (Table 5-4) Table 5-5 Operating income or loss LO3

©2009 McGraw-Hill Ryerson Limited 17 of 28 FIGURE 5-3 Nonlinear break-even analysis Profit Loss LO3

©2009 McGraw-Hill Ryerson Limited 18 of 28 Financial Leverage Measure of the amount of debt used by a firm Degree of Financial Leverage (DFL) = %age  in EPS %age  in EBIT (or OI) a  in EBIT (or OI)  a larger  in EPS if DFL > 1 DFL measures the sensitivity of a firm’s earnings per share to a  in operating income. LO3

©2009 McGraw-Hill Ryerson Limited 19 of 28 TABLE 5-6 Impact of financing plan on earnings per share LO4

©2009 McGraw-Hill Ryerson Limited 20 of 28 Indifference Point the level of EBIT at which alternative financing plans yield the same earnings per share (EPS) Mathematically, LO4

©2009 McGraw-Hill Ryerson Limited 21 of 28 FIGURE 5-4 Financing plans and earnings per share LO4

©2009 McGraw-Hill Ryerson Limited 22 of 28 Figure 5-5 Financial leverage in selected industries LO4 Source: Statistics Canada, “Quarterly Financial Statistics for Enterprises”, Catalogue X, First quarter, 2008

©2009 McGraw-Hill Ryerson Limited 23 of 28 Combined or Total Leverage Represents maximum use of leverage Degree of Combined Leverage (DCL ) = %age  in EPS %age  in Sales a  in Sales  a larger  in EPS if DCL > 1 Short-cut formula: DCL or DTL = DOL x DFL LO5

©2009 McGraw-Hill Ryerson Limited 24 of 28 FIGURE 5-6 Combining operating and financial leverage LO5

©2009 McGraw-Hill Ryerson Limited 25 of 28 Table 5-7 Operating and financial leverage Sales — $2 per unit $160,000$200,000 — Variable costs ($0.80 per unit)64,00080,000 Contribution margin $96,000 $120,000 — Fixed costs 60,00060,000 Operating income (EBIT) 36,00060,000 — Interest12,00012,000 Earnings before taxes24,00048,000 — Taxes12,00024,000 Earnings aftertaxes$ 12,000$ 24,000 Shares8,0008,000 Earnings per share$1.50$3.00 (80,000 units)(100,000 units) (Taken from Table 5-6) LO5

©2009 McGraw-Hill Ryerson Limited 26 of 28 Formula Review LO2/LO3/LO4 DCL = DOL × DFL

©2009 McGraw-Hill Ryerson Limited 27 of 28 Summary and Conclusions Leverage refers to the use of fixed costs to magnify the profits (or losses) of a firm It is a double-edged sword. Management must be sure of the level of risk assumed Operating leverage refers to using fixed operating costs, such as lease or amortization expense The degree of operating leverage (DOL) measures the %age change in operating income as a result of a %age change in sales

©2009 McGraw-Hill Ryerson Limited 28 of 28 Summary and Conclusions Financial leverage refers to the fixed financing charge such as interest cost on debt The degree of financial leverage (DFL) measures the %age change in earnings per share (EPS) as a result of a %age change in operating income The higher the level of fixed costs (both operating and financing costs), the greater the effect on net income of an increase in sales revenue (This is the degree of combined leverage (DCL))