1. Topic 7: Analysis & Impact ofLaverage Team BRAcct’s : Naim Amirul

2. What is Leverage? O The use of borrowed money to increase production volume, and thus sales and earnings. O It is measured as the ratio of total debt to total assets.

3. Types of leverages O Operating Leverage: Operating leverage, just like the financial leverage, is a result of operating fixed expenses. Higher the fixed expense, higher is the operating leverage. O Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital structure of a company.

4. Breakeven Point Breakeven point (units of output) O Q B = breakeven level of Q. O F = total anticipated fixed costs. O P = sales price per unit. O V = variable cost per unit. Q B = F P - V

5. Breakeven Point (Cont’d) Breakeven point (sales dollars) O S* = breakeven level of sales. O F = total anticipated fixed costs. O S = total sales. O VC = total variable costs. S* = F VC S 1 -

6. Degree of Operating Leverage DOLs = % change in EBIT % change in sales change in EBIT EBIT change in sales sales =

7. Degree of Operating Leverage (Cont’d) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs EBIT

8. Degree of Operating Leverage (Cont’d) O If DOL = 4, then a 1% increase in sales will result in a 4% increase in operating income (EBIT).

9. Degree of Financial Leverage DFL = % change in EPS % change in EBIT change in EPS EPS change in EBIT EBIT =

10. Degree of Financial Leverage (Cont’d) DFL = EBIT EBIT - I

11. Degree of Financial Leverage (Cont’d) O If DFL = 2, then a 1% increase in operating income will result in a 2% increase in earnings per share.

12. Degree of Combined Leverage DCL = DOL x DFL = % change in EPS % change in Sales change in EPS EPS change in Sales Sales =

13. Degree of Combined Leverage (Cont’d) DCL = Sales - Variable Costs EBIT - I Q(P - V) Q(P - V) - F - I =

14. Degree of Combined Leverage (Cont’d) O If DCL = 4.5, then a 1% increase in sales will result in a 4.5% increase in earnings per share.

15. Optimal Capital Structure O The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value. O Either to take Leverage or Cost of Capital O By using EBIT-EPS Analysis

16. EBIT-EPS Analysis EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

17. Breakeven Point Stock Financing Debt Financing (Alternative 1)(Alternative 2) (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S

18. Thank You