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Chapter 5 Operating and Financial Leverage
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-1 FIGURE 5-1 Break-even chart: Leveraged firm
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-2 TABLE 5-2 Volume-cost-profit analysis: Leveraged firm
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-3 FIGURE 5-2 Break-even chart: Conservative firm
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-4 TABLE 5-3 Volume-cost-profit analysis: Conservative firm
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-5 TABLE 5-4 Operating income or loss
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-6 FIGURE 5-3 Nonlinear break-even analysis
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-7 FIGURE 5-4 Financing plans and earnings per share
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-8 TABLE 5-5 Impact of financing plan on earnings per share
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-9 TABLE 5-6 Income statement
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-10 FIGURE 5-5 Combining operating and financial leverage
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-11 TABLE 5-7 Operating and financial leverage
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 5 - Outline LT 5-1 What is Leverage? Break-Even (BE) Point Operating Leverage Financial Leverage Leverage Means Risk Combined or Total Leverage
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. What is Leverage? LT 5-2 Leverage is using fixed costs to magnify the potential return to a firm 2 types of fixed costs: – fixed operating costs = rent, depreciation – fixed financial costs = i costs from debt
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Break-Even (BE) Point Quantity where Total Revenue equals Total Cost Company has no Profit or Loss BE = FC / P – VC A leveraged firm has a high BE point A non-leveraged firm has a low BE point LT 5-3
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Operating Leverage LT 5-4 Measure of 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) Operating Leverage measures the sensitivity of a firm’s operating income to a in sales
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Leverage LT 5-5 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 Financial Leverage measures the sensitivity of a firm’s earnings per share to a in operating income
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Leverage Means Risk LT 5-6 Leverage is a double-edged sword It magnifies profits as well as losses An aggressive or highly leveraged firm has high fixed costs (and a relatively high break-even point) A conservative or non-leveraged firm has low fixed costs (and a relatively low break-even point) Many Japanese firms tend to be highly leveraged
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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. Combined or Total Leverage LT 5-7 Represents maximum use of leverage Degree of Combined or Total Leverage (DCL or DTL) = %age in EPS / %age in Sales a in Sales a larger in EPS Short-cut formula: DCL or DTL = DOL x DFL
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