1. Operating and Financial Leverage
Chapter 5
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline What is leverage? Break-even analysis
Operating leverage
Financial leverage
Combined leverage
Potential profits or increased risk?

3. What is Leverage?
Use of special forces and effects to magnify or produce more than normal results from a given course of action
Can produce beneficial results in favorable conditions
Can produce highly negative results in unfavorable conditions

4. Leverage in a Business Determining type of fixed operational costs
Plant and equipment
Eliminates labor in production of inventory
Expensive labor
Lessens opportunity for profit but reduces risk exposure
Determining type of fixed financial costs
Debt financing
Substantial profits but failure to meet contractual obligations can result in bankruptcy
Selling equity
Reduces potential profits but minimizes risk exposure

5. Operating Leverage
Extent to which fixed assets and associated fixed costs are utilized in a business
Operational costs include:
Fixed
Variable
Semivariable

6. Break-Even Chart: Leveraged Firm

7. Break-Even Analysis
The break-even point is at 50,000 units, where the total costs and total revenue lines intersect
Units = 50,
Total Variable Fixed Costs Total Costs Total Revenue Operating Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40, $60, $100, $100,

8. Break-Even Analysis (cont’d)
The break-even point can also be calculated by:
Fixed costs = Fixed costs = FC
Contribution margin Price – Variable cost per unit P – VC
i.e $60, = $60,000 = 50,000 units
$ $ $1.20

9. Volume-Cost-Profit Analysis: Leveraged Firm
Table 5-2

10. A Conservative Approach
Some firms choose not to operate at high degrees of operating leverage
More expensive variable costs may be substituted for automated plant and equipment
This approach may cut into potential profitability of the firm

11. Break-Even Chart: Conservative Firm

12. Volume-Cost-Profit Analysis: Conservative Firm
Table 5-3

13. The Risk Factor
Factors influencing decision on maintaining a conservative or leveraged position include:
Economic condition
Competitive position within industry
Future position – stability versus market leadership
Matching an acceptable return with a desired level of risk

14. Cash Break-Even Analysis
Deals with cash flows rather than accounting flows
Helps in analyzing the short-term outlook of a firm
Examples of noncash items that are excluded:
Depreciation
Credit sales
Credit purchase of materials

15. Degree of Operating Leverage (DOL)
Percentage change in operating income as a result of a percentage change in units sold
Computed only over a profitable range of operations
More when it is computed closer to BEP
DOL = Percent change in operating income
Percent change in unit volume

16. Operating Income or Loss

17. Computation of DOL Leveraged firm:
DOL = Percent change in operating income = $24,000 X 100
Percent change in unit volume $36,000
20,000 X 100
80,000
= % = 2.7
25%
Conservative firm:
DOL = Percent change in operating income = $8,000 X 100
Percent change in unit volume $20,000
= 40% = 1.6

18. Algebraic Formula for DOL
DOL = Q (P – VC) ,
Q (P – VC) – FC
Where,
Q = Quantity at which DOL is computed
P = Price per unit
VC = Variable costs per unit
FC = Fixed costs
For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80, and FC = $60,000:
DOL = ,000 ($ $0.80) ;
80,000 ($ $0.80) - $60,000
= ,000 ($1.20) = $96, ;
80,000 ($1.20) - $60, $96,000 - $60,000
DOL = 2.7

19. Limitations of Analysis
Assumption of existence of constant or linear function for revenues and costs as volume changes
May not hold good in real world
Price weakening to capture increasing market
Cost overruns when moved beyond optimum-size operation
Relationships are not so fixed as assumed

20. Nonlinear Break-Even Analysis
Assumption of exact linear relation does not hold good in reality

21. Financial Leverage
Reflects the amount of debt used in the capital structure of the firm
Determines how the operation is to be financed
Determines the performance between two firms having equal operating capabilities
BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage

22. Impact on Earnings
Examine two financial plans for a firm, where $200,000 is required to carry the assets
Total Assets = $200,000
Plan A (leveraged) Plan B (conservative)
Debt (8% interest) $150,000 ($12,000 interest) $ 50,000 ($4,000 interest)
Common stock ,000 (8000 shares at $6.25) ,000 (24,000 shares at $6.25)
Total financing $200, $200,000

23. Impact of Financing Plan on Earnings per Share
Table 5-5

24. Financing Plans and Earnings per Share

25. Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT
For the purpose of computation, it can be restated as:
DFL = EBIT .
EBIT – I
DFL for two plans can be calculated using values from Table 5-5
Plan A (Leveraged):
DFL = EBIT = $36, = $36,000 = 1.5
EBIT – I $36,000 - $12, $24,000
Plan B (Conservative):
DFL = EBIT = $36, = $36,000 = 1.1
EBIT – I $36,000 - $4, $32,000

26. Limitations to Use of Financial Leverage
Beyond a point, debt financing is detrimental to the firm
Lenders will perceive a greater financial risk
Common stockholders may drive down the price
Recommended for firms that are:
In an industry that is generally stable
In a positive stage of growth
Operating in favorable economic conditions

27. Combining Operating and Financial Leverage
Combined leverage: when both leverages allow a firm to maximize returns
Operating leverage:
Affects the asset structure of the firm
Determines the return from operations
Financial leverage:
Affects the debt-equity mix
Determines how the benefits received will be allocated

28. Combined Leverage Influence on the Income Statement
Last item under operating leverage, operating income, becomes the initial item for determining financial leverage
“Operating income” and “Earnings before interest and taxes” are one and the same, representing the return to the owners before interest and taxes are paid

29. Combining Operating and Financial Leverage

30. Operating and Financial Leverage
Table 5-7

31. Degree of Combined Leverage
Uses the entire income statement
Shows the impact of a change in sales or volume on bottom-line earnings per share
DCL = Percentage change in EPS ;
Percentage change in sales (or volume)
Using data from Table 5-7:
Percent change in EPS $1.50 X 100
$ = 100% = 4
Percent change in sales $40,000 X %
$160,000 =

32. Degree of Combined Leverage (cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) = $12,000.
DCL = ,000 ($2.00 – $0.80) =
80,000 ($ $0.80) – $60,000 – $12,000
= ,000 ($1.20) =
80,000 ($1.20) – $72,000
DCL = $96, = $96,000 = 4
$96,000 – $72, $24,000