1. Breakeven and Leverage
Part of Chapter 13

2. Operating, financial and total leverage
Read parts of chapter related to breakeven and leverage (DOL, DFL, DTL)
Breakeven
Operating, financial and total leverage
Risk
Capital structure is a risk decision and that is why this is in chapter 13, but the parts we are pulling out of chapter 13 now rely on the income statement and fit well with what we have covered in chapter 3 and AFN.

3. Breakeven Analysis
Used to determine the level of sales a firm must achieve to stay in business in the long run
Shows the mix of fixed and variable cost and the volume required for zero profit/loss
Profit/loss generally measured by EBIT (operating profit/loss)

4. Breakeven Analysis Breakeven Diagrams
Sales level is considered the big uncertainty
Operating Breakeven occurs at the intersection of revenue and total operating cost
Represents the level of sales at which revenue equals cost
Usually operating breakeven (interest ignored)
And financial breakeven
Need variable cost–fixed cost breakdown
Variable cost per unit assumed constant

5. Figure 13.5: The Breakeven Diagram
Write Equations for Cost and Revenue on the board
REV=PQ
Total Cost = VQ + FC

6. Breakeven Analysis The Contribution Margin
Every sale makes a ‘contribution’ per unit of the difference between price (P) and variable cost (V)
Ct = P – V
Can be expressed as a percentage of the price
Known as the contribution margin (CM)
CM = (P – V) / P

7. Breakeven Analysis—Example
Q: Suppose a company can make a unit of product for $7 in variable labor and materials, and sell it for $10. What are the contribution and contribution margin?
A: The contribution per unit is $3, or $10 - $7, while the contribution margin is $3 / $10, or 30%.
Example

8. Operating Breakeven Analysis
Calculating the Breakeven Sales Level
EBIT is revenue minus cost, or
EBIT = PQ – VQ – FC
Find breakeven quantity by setting EBIT equal to zero and solve for Q.
Breakeven occurs when revenue (PQ) equals total cost (VQ + FC):
QB/E = FC / (P – V)
Breakeven tells us how many units have to be sold to contribute enough money to pay for fixed costs
Can also be expressed in terms of dollar sales
SB/E = P(FC) / (P – V) or FC / CM
Look at the math on the board

9. Breakeven Analysis—Example
Q: What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month?
A: The breakeven point in units is $1,800  ($10 - $7) = 600 units. The breakeven point in dollars (sales) is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800  Thus, the firm must sell 600 units per month to cover fixed costs.
Example

10. Risk in the Context of Leverage
skim
Leverage potentially affects the stock price
Alters the risk/return relationship in an equity investment
Measures of performance
Operating income (AKA: EBIT)
Unaffected by leverage because it is calculated prior to the deduction for interest
Return on Equity (ROE) is Net Income  Stockholders’ Equity
Earnings per Share (EPS) is Net Income  number of shares
Investors regard EPS as an important indicator of future profitability

11. Risk in the Context of Leverage
Redefining Risk for Leverage-Related Issues
Leverage-related risk is variation in ROE and EPS
Business risk—variation in EBIT
Financial risk—additional variation in ROE and EPS brought about by financial leverage

12. Leverage and Risk—Two Kinds
1. Operating leverage (operating risk) and 2.Financial leverage (financial risk)
Operating leverage affects a firm’s business risk
Relates to a company’s cost structure
Involves relative use of fixed versus variable costs (more fixed cost is more operating leverage)
If doing a task with a fixed cost is cheaper than doing it with a variable cost then operating leverage will improve a firm’s ROE and EPS

13. Operating Leverage Terminology and Definitions
Risk in Operations—Business Risk
Variation in EBIT
Fixed and Variable Costs and Cost Structure
Fixed costs don’t change with the level of sales, while variable costs do
Fixed costs include rent, depreciation, utilities, salaries
Variable costs include direct labor, direct materials, sales commissions
The mix of fixed and variable costs in a firm’s operations is its cost structure
Operating Leverage Defined
Refers to the amount of fixed costs in the cost structure

14. The Effect of Operating Leverage
As volume moves away from breakeven, profit or loss increases faster with more operating leverage
The Risk Effect
More operating leverage leads to larger variations in EBIT, or business risk
The Effect on Expected EBIT
Thus, when a firm is operating above breakeven, more operating leverage implies higher operating profit
If a firm is relatively sure of its sales level, it is in the firm’s best interests to trade variable costs for fixed cost (assuming the firm is operating above breakeven)

15. Figure 13.6: Breakeven Diagram at High and Low Operating Leverage
Diagram shows the common tradeoff of higher fixed cost and lower variable cost (lower slope on total cost line)

16. The Degree of Operating Leverage (DOL)—A Measurement
Operating leverage amplifies changes in sales volume into larger changes in EBIT
DOL relates relative changes in volume (Q) to relative changes in EBIT

18. The Degree of Operating Leverage (DOL)—A Measurement
Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level.
A: First, compute the breakeven volume: $600  ($10 - $7) = 200 units. Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200 x 1.50 or 300 units. DOL at 210 units is:
DOL at 300 units is:
Example
Note that DOL decreases
as the output level
increases above
breakeven.

19. Financial Leverage
The use of borrowed money incurs interest, which is like a fixed cost
If returns are greater than the interest rate then financial leverage will improve a firm’s ROE and EPS
However, if returns are lower than the interest rate then borrowing money will worsen EPS and ROE

20. Financial Leverage
Return on Capital Employed, ROCE (also called Basic Earnings Power, BEP)
Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE
When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS
When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse

21. Table 13.1 (the good side of debt)
As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.

22. Table 13.2 (the bad side of debt)
ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.

23. Financial Leverage and Financial Risk
skim
Financial leverage is a two-edged sword
Multiplies good results into great results
Multiplies bad results into terrible results
ROE and EPS for leveraged firms experience more variation
Financial risk is the increased variability in financial results that comes from additional leverage

24. The Degree of Financial Leverage (DFL)—A Measurement
Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS
The degree of financial leverage (DFL) relates relative changes in EBIT to relative changes in EPS
Calculate DFL:
Write this down to use as we go along

25. EPS = [(EBIT – I)(1 – t)] / shares

26. The Degree of Financial Leverage (DFL)—A Measurement—Example
Q: Selected income statement and capital information for the Moberly Manufacturing Company follow ($000):
Example
Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest on its debt and anticipates that it can borrow as much as it reasonably needs at that rate. The income tax rate is 40%
Moberly is interested in boosting the price of its stock. To do that management is considering restructuring capital to 50% debt in the hope that the increased EPS will have a positive effect on price. However, the economic outlook is shaky, and the company’s CFO thinks there’s a good chance that a deterioration in business conditions will reduce EBIT next year. At the moment Moberly’s stock sells for its book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to assess the increase in risk that will come along with it.
$8,000
Total
$1,380
EBIT
7,000
Equity
4,200
Cost/expense
$1,000
Debt
$5,580
Revenue
Capital

27. The Degree of Financial Leverage (DFL)—A Measurement (Example)
A: Since the equity is trading at book value, this is a relatively simple example.
Example
400,000
700,000
Shares outstanding
Proposed
Current
$8,000
Total
4,000
7,000
Equity
$4,000
$1,000
Debt
Capital
$1.170
$1.054
EPS
$468
$738
EAT
312
492
Tax
$780
$1,230
EBT
600
150
Interest (15% of debt)
$1,380
EBIT
If business conditions remain unchanged, a higher EPS will result with the addition of debt.

28. The Degree of Financial Leverage (DFL)—A Measurement—Example
A: Next, calculate DFL:
Example
EPS will be much more volatile under the proposed plan. When EBIT changes, EPS will change by a factor of 1.77 vs

29. Comparing Operating and Financial Leverage
Financial and operating leverage are similar in that both can enhance results while increasing variation
Financial leverage involves substituting debt for equity in the firm’s capital structure
Operating leverage involves substituting fixed costs for variable costs in the firm’s cost structure
Both methods involve substituting fixed cash outflows for variable cash outflows
Both kinds of leverage make their respective risks larger as the levels of leverage increase
However, financial risk is non-existent if debt is not present, while business risk would still exist even if no operating leverage existed
Financial leverage is more controllable than operating leverage

30. The Compounding Effect of Operating and Financial Leverage
The effects of financial and operating leverage compound one another
Changes in sales are amplified by operating leverage into larger relative changes in EBIT
Which in turn are amplified into still larger relative changes in ROE and EPS by financial leverage
The effect is multiplicative, not additive
Thus, fairly modest changes in sales can lead to dramatic changes in ROE and EPS
The combined effect can be measured using degree of total leverage (DTL)
DTL = DOL × DFL

31. The Compounding Effect of Operating and Financial Leverage—Example
Q: The Allegheny Company is considering replacing a manual production process with a machine. The money to buy the machine will be borrowed. The replacement of people with a machine will alter the firm’s cost structure in favor of fixed costs, while the loan will move the capital structure in the direction of more debt. The firm’s leverage positions at expected output levels with and without the project are summarized as follows:
The economic outlook is uncertain and some managers fear a decline in sales of as much as 10% in the coming year. Evaluate the effect of the proposed project on risk in financial performance.
A: The firm’s current DTL is 2 x 1.5, or 3, meaning a 10% decline in sales could result in a 30% decline in EPS. Under the proposal, the DTL will be much higher: 8.75, or 3.5 x 2.5, meaning a 10% drop in sales could lead to a 87.5% drop in EPS.
Example
2.5
3.5
Proposed
1.5
2.0
Current
DFL
DOL