215 Chap05 Leverage

8/8/2019 215 Chap05 Leverage

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Chapter 5

Operating and FinancialLeverage


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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 RiskCombined or Total Leverage


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What is Leverage? LT 5-2

Leverage is using fixed costs to magnify the potential returnto a firm

2 types of fixed costs:

fixed operating costs = rent, depreciation

fixed financial costs = i costs from debt


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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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Break-Even (BE) Point

Quantity where Total Revenue equals Total Cost

Company has no Profit or Loss

BE = Fixed Costs / (Price Variable Costs) A leveraged firm has a high BE point

A non-leveraged firm has a low BE point

LT 5-3


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Operating Leverage LT 5-4

Measure of the amount of fixed operating costs used by afirm

Degree of Operating Leverage (DOL) = %age

in EBIT (orOI) / %age in Sales

a in Sales p a larger in EBIT (or OI)

Operating Leverage measures the sensitivity of a firmsoperating income to a in sales


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FIGURE 5-1Break-even

chart:

Leveragedfirm


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PPT 5-4TABLE 5-3

Volume-cost-profit analysis: Conservative firm

Price/Unit 2.00$

VC / Unit 1.60$

Units Sold

Total

Variable

Costs

Fixed

Costs Total Costs

Total

Revenue

Operating

Income

(Loss)- -$ 12,000$ 12,000$ -$ (12,000)

20,000 32,000$ 12,000$ 44,000$ 40,000$ (4,000)

30,000 48,000$ 12,000$ 60,000$ 60,000$ -

40,000 64,000$ 12,000$ 76,000$ 80,000$ 4,000

60,000 96,000$ 12,000$ 108,000$ 120,000$ 12,000

80,000 128,000$ 12,000$ 140,000$ 160,000$ 20,000

100,000 160,000$ 12,000$ 172,000$ 200,000$ 28,000


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5-3FIGURE 5-2Break-even

chart:

Conservativefirm


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PPT 5-5TABLE 5-4Operating income or loss

Units

Sold

Leveraged

Firm

Conservative

Firm

- (60,000) (12,000)20 000 (36,000) (4,000)

40 000 (12,000) -

50 000 - 4,000

60 000 12,000 12,000

80 000 36,000 20,000

100 000 60,000 28,000


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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) p a larger in EPS

Financial Leverage measures the sensitivity of a firmsearnings per share to a in operating income


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5-8

TABLE 5-5Impact ofFinancing plan on earnings/share

Earnings before Interest and taxes (EBIT)= $0.00

Plan A

(Leveraged)

Plan B

(Conservative)

Earnings before Interest and taxes (EBIT) $0 $0Less Interest Payments (I) ($12,000) ($4,000)

equals Earnings Before Taxes (EBT) ($12,000) ($4,000)

Less Taxes (T) (assume 50%) $6,000 $2,000

equals Earnings Before Taxes (EBT) ($6,000) ($2,000)

divided by No. of Shares Outstanding $8,000 $24,000equals Earnings Per Share (EPS) ($0.750) ($0.083)


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5-8


Earnings before Interest and taxes (EBIT)= $12,000.00

Plan A

(Leveraged)

Plan B

(Conservative)

Earnings before Interest and taxes (EBIT) $12,000 $12,000

Less Interest Payments (I) ($12,000) ($4,000)

equals Earnings Before Taxes (EBT) $0 $8,000

Less Taxes (T) (assume 50%) $0 ($4,000)

equals Earnings Before Taxes (EBT) $0 $4,000

divided by No. of Shares Outstanding $8,000 $24,000equals Earnings Per Share (EPS) $0.000 $0.167


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5-8



Plan A

(Leveraged)

Plan B

( onservative)


Less Interest Payments (I) ($12,000) ($4,000)equals Earnings Before Taxes (EBT) $4,000 $12,000

Less Taxes (T) (assume 50%) ($2,000) ($6,000)

equals Earnings Before Taxes (EBT) $2,000 $6,000

divided by No. of Shares Outstanding $8,000 $24,000

equals Earnings PerShare (EPS) $0.250 $0.250


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5-8



Plan A

(Leveraged)

Plan B

(Conservative)








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5-8



Plan A

(Leveraged)

Plan B

(Conservative)








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5-8


Earnings before Interest and taxes (EBIT)EPS Plan A

(Leveraged)

EPS Plan B

(Conservative)

$0 ($0.75) ($0.08)

$12,000 $0.00 $0.17

$16,000 $0.25 $0.25$36,000 $1.50 $0.67

$60,000 $3.00 $1.17


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PPT 5-7FIGURE 5-4Financing plans

and

earningsper share


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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 p a larger in EPS

Short-cut formula:

DCL or DTL = DOL x DFL


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PPT 5-9TABLE 5-6

Income statement


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PPT 5-10FIGURE 5-5Combining

operating

and financialleverage

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215 Chap05 Leverage