1. Chapter 5 Operating and Financial Leverage

2. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-1 FIGURE 5-1 Break-even chart: Leveraged firm

3. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-2 TABLE 5-2 Volume-cost-profit analysis: Leveraged firm

4. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-3 FIGURE 5-2 Break-even chart: Conservative firm

5. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-4 TABLE 5-3 Volume-cost-profit analysis: Conservative firm

6. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-5 TABLE 5-4 Operating income or loss

7. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-6 FIGURE 5-3 Nonlinear break-even analysis

8. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-7 FIGURE 5-4 Financing plans and earnings per share

9. 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

10. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-9 TABLE 5-6 Income statement

11. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-10 FIGURE 5-5 Combining operating and financial leverage

12. McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved. PPT 5-11 TABLE 5-7 Operating and financial leverage

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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