Topic3 Financial and Operating Leveraging-Edited-231111_084005

8/3/2019 Topic3 Financial and Operating Leveraging-Edited-231111_084005

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Topic 3Financial and OperatingLeveraging

Business vs. financial risk

Operating leverage Financial Leverage

Degree of Financial & Operating Leverage


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Uncertainty about future operating income (EBIT),i.e., how well can we predict operating income?

Note that business risk does not include financingeffects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk


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What determines business risk? Uncertainty about demand (sales).

Uncertainty about output prices.

Uncertainty about costs.

Product, other types of liability.

Operating leverage.


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What is operating leverage, and how

does it affect a firms business risk? Operating leverage is the use of fixed costs

rather than variable costs.

If most costs are fixed, hence do not decline

when demand falls, then the firm has highoperating leverage.

A business that makes few sales, with each saleproviding a very high gross margin, is said to behighly leveraged. A business that makes manysales, with each sale contributing a very slightmargin, is said to be less leveraged.


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Effect of operating leverage More operating leverage leads to more business risk,

for then a small sales decline causes a big profitdecline.

For example, convenience stores are significantly less

leveraged than high-end car dealerships

Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

} Profit


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Using operating leverage

Typical situation: Can use operating leverageto get higher E(EBIT), but risk also increases.

Probability

EBITL

Low operating leverage

High operating leverage

EBITH


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What is financial leverage?

Financial risk? Financial leverage is the use of debt

and preferred stock.

Financial risk is the additional riskconcentrated on commonstockholders as a result of financialleverage.


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Business risk vs. Financial risk Business risk depends on business

factors such as competition, product

liability, and operating leverage. Financial risk depends only on the

types of securities issued. More debt, more financial risk.

Concentrates business risk onstockholders.


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An example:

Illustrating effects of financial leverage Two firms with the same operating leverage,

business risk, and probability distribution ofEBIT.

Only differ with respect to their use of debt(capital structure).

Firm U Firm L

No debt $10,000 of 12% debt

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate


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Firm U: UnleveragedEconomy

Bad Avg. Good

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000

Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400


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Firm L: LeveragedEconomy

Bad Avg. GoodProb.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.


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Ratio comparison between

leveraged and unleveraged firmsFIRM U Bad Avg GoodBEP* 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%

TIE

FIRM L Bad Avg GoodBEP* 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%

TIE 1.67x 2.50x 3.30x

*BEP (Basic earning power)


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Risk and return for leveraged

and unleveraged firmsExpected Values:

Firm U Firm L

E(BEP) 15.0% 15.0%E(ROE) 9.0% 10.8%E(TIE) 2.5x

Risk Measures:Firm U Firm L

ROE 2.12% 4.24%


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The effect of leverage on

profitability and debt coverage For leverage to raise expected ROE, must

have BEP > kd.

Why? If kd > BEP, then the interest expensewill be higher than the operating incomeproduced by debt-financed assets, soleverage will depress income.

As debt increases, TIE decreases becauseEBIT is unaffected by debt, and interestexpense increases (Int Exp = kdD).


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Conclusions Basic earning power (BEP) is

unaffected by financial leverage.

L has higher expected ROE becauseBEP > kd.

L has much wider ROE (and EPS)swings because of fixed interest

charges. Its higher expected returnis accompanied by higher risk.


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Breakeven Analysis

Breakeven Analysis is used to:

determine the level of operations necessary to

cover all operating costs, and

evaluate the profitability associated with variouslevels of sales.

The firms operating breakeven point (OBP) is the level

of sales necessary to cover all operating expenses.


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Breakeven Analysis To calculate the OBP, cost of goods sold and operating

expenses must be categorized as fixed or variable.

Variable costs vary directly with the level of sales and

are a function of volume, not time.

Fixed costs are a function of time and do not vary with

sales volume.


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Algebraic Approach

P = sales price per unit

Q = sales quantity in units

FC = fixed operating costs per period

VC = variable operating costs per unit

EBIT = (P x Q) - FC - (VC x Q) Letting EBIT = 0 and solving for Q, we get:

Breakeven Analysis


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Using the following variables, the operating portion of

a firms income statement may be recast as follows:

Algebraic/Equation Approach

P = sales price per unit

Q = sales quantity in units

FC = fixed operating costs per period

VC = variable operating costs per unit

Q = FC

P - VC

Breakeven Analysis


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Algebraic Approach

Breakeven Analysis


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Example: Omnibus Posters has fixed operating costs

of $2,500, a sales price of $10/poster, and variable

costs of $5/poster. Find the OBP.

Algebraic Approach

Q = $2,500 = 500 posters

$10 - $5

Breakeven Analysis

$ = 500 X $10 = $5000


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We can check to verify that this is the case by

substituting as follows:

Algebraic Approach

EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

EBIT = $5,000 - $2,500 - $2,500 =$0


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Breakeven Analysis

The contribution margin method is a variationof the equation method.

Fixed expensesUnit contribution margin=Break-even pointin units sold

Fixed expenses

CM ratio

=Break-even point in

total sales dollars

Contribution Margin Approach

$ = $2,500 = $50000.5

Q = $2,500 = 500 posters$10 - $5

Fixed expenses(Sales-VC)/Sales

=


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Graphic Approach

Quantity Total Total Total Total

Sold Revenue Costs FC VC EBIT

- - 2,500 2,500 - (2,500)

500 5,000 7,500 2,500 2,500 -

1,000 10,000 12,500 2,500 5,000 2,500

1,500 15,000 17,500 2,500 7,500 5,000

2,000 20,000 22,500 2,500 10,000 7,500

2,500 25,000 27,500 2,500 12,500 10,000

3,000 30,000 15,000 2,500 15,000 12,500

EBIT at Various Levels of Quantit Sold

Breakeven Analysis


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-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

- 500 1,000 1,500 2,000

sales (posters)

revenue/costs

($)

Total Revenue Total Costs Total FC

Breakeven Analysis


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Target Profit Analysis

We can use our Cost Volume profit (CVP)

formula to determine the sales volumeneeded to achieve a target net profitfigure.


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CVP Equation Method

Q = $2,500 + $500 = 600 posters

$10 - $5

$ = 600 X $10 = $6000

LET SAY YOUR TARGET PROFIT IS $500



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The contribution margin method is a variationof the equation method.

Fixed expensesUnit contribution margin=Unit sales to attainthe target profit

Fixed expenses

CM ratio

=total sales dollars toAttain the target profit

Contribution Margin Approach

$ = $2,500 + 500 = $60000.5

Q = $2,500 + 500 = 600 posters$10 - $5

Fixed expenses(Sales-VC)/Sales

=


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Margin of safety (MOS) is the excessof budgeted or actual sales over the

breakeven volume of sales. It state theamount by which sales can drop beforelosses begin to be incurred. The higher

the margin of safety, the lower the riskof not breaking even.

Margin of Safety (MOS)
http://www.accountingformanagement.com/break_even_point_definition.htmhttp://www.accountingformanagement.com/break_even_point_definition.htm


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Margin of Safety (MOS)

MOS = Total Actual Sales BE sales

Let say; BE = $5000, Sales = $5500

Therefore MOS = 5500 5000= 500

If in %, MOS(%) = 500/5000

= 0.1 or 10%Therefore if reduction in sales of $500 or 10%,the result will be just break even.

O i & Fi i l L


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Operating & Financial Leverage

O ti & Fi i l L


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Scenario 1 Scenario 2 Scenario 3

10% Sales Sales Rem ain 10% Sales

Decrease Unchanged Increase

Net Sales 630,000$ 700,000$ 770,000$

Less: Variable Costs

(60% of Sales) 378,000 420,000 462,000

Less: Fixed Costs 200,000 200,000 200,000

EBIT 52,000 80,000 108,000Less: Interest Expens 20,000 20,000 20,000

EBT 32,000 60,000 88,000

Less: Taxes (30%) 9,600 18,000 26,400

Net Income 22,400$ 42,000$ 61,600$

Effects of Leverage on the Income Statement


O ti & Fi i l L


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Degree of Operating Leverage

The degree of operating leverage (DOL) measures the

sensitivity of changes in EBIT to changes in Sales.

A companys DOL can be calculated in two different

ways: One calculation will give you a point estimate,

the other will yield an interval estimate of DOL.


O ti & Fi i l L


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Scenario 1 Scenario 2 Scenario 3Sales Decrease Sales Rem ain Sales Increase

10.0% Unchanged 10.0%

Net Sales 630,000$ 700,000$ 770,000$

Les s: Variable Costs

(60% of Sales ) 378,000 420,000 462,000

Les s: Fixed Costs 200,000 200,000 200,000

EBIT 52,000 80,000 108,000

Ebit Decreases Ebit Increases

(52-80)/80 35.0% (108-80)/80 35.0%

Effects of Operating Leverage on the Income Statement

O ti & Fi i l L


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Interval Estimate of DOL

DOL = % Change in EBIT = 35% = 3.50 x

% Change in Sales 10%



O ti & Fi i l L


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Point Estimate of DOL

DOL = Sales - VC = 700 - 420 = 3.50 xSales - VC - FC 700 - 420 - 200



DOL = CM

EBIT

O ti & Fi i l L


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Degree of Financial Leverage

The degree of financial leverage (DFL) measures the

sensitivity of changes in EPS to changes in EBIT.

Only companies that use debt or other forms of fixed

cost financing (debt or PS) will experience financial

leverage.


O ti & Fi i l L


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EBIT Dcrease Sales Remain EBIT Increase

35.00% Unchanged 35.00%

EBIT 52,000 80,000 108,000

Less: Interest Expens 20,000 20,000 20,000

EBT 32,000 60,000 88,000

Less: Taxes (30%) 9,600 18,000 26,400

Net Income 22,400$ 42,000$ 61,600$

EPS (42,000 shares) 0.533$ 1.00$ 1.467$

EPS Decreases EPS Increases

46.67% 46.67%

Effects of Financial Leverage on the Income Statement

O ti & Fi i l L


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Interval Estimate ofDFL

DFL = % Change in EPS = 46.67% = 1.33

% Change in EBIT 35.00%





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Point Estimate of DFL

DFL = EBIT = 80 = 1.33EBIT - Interest 80 - 20

DFL = EBIT = 108 = 1.23EBIT - Interest 108 - 20



Ope ating & Financial Le e age


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10% Sales Sales Remain 10% Sales

Decrease Unchanged Increase

Net Sales 630,000$ 700,000$ 770,000$Less: Variable Costs

(60% of Sales) 378,000 420,000 462,000

Less: Fixed Costs 200,000 200,000 200,000

EBIT 52,000 80,000 108,000

Less: Interest Expens 20,000 20,000 20,000EBT 32,000 60,000 88,000

Less: Taxes (30%) 9,600 18,000 26,400

Net Income 22,400$ 42,000$ 61,600$

EPS (42,000 shares) 0.53$ 1.00$ 1.47$

EPS Decreases EPS Increases46.67% 46.67%

Effects of Combined Leverage on the Income Statement

Degree of Total Leverage



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Interval Estimate ofDTL

DTL = % Change in EPS = 46.7% = 4.67

% Change in Sales 10%





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Point Estimate of DTL

DTL = Q x (P - VC)

Q x (P-VC) - FC - I



DTL = 700 - 420 = 4.67

700 - 420 - 200 - 20



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DTL = DOL x DFL



DTL = 3.50 x 1.33 = 4.6

Applying this to our example at a sales level of $77, we get:

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Topic3 Financial and Operating Leveraging-Edited-231111_084005