Operating Leverage - Finacial leverage & Break-Even

Break-Even and Leverage

Operating LeverageOperating Leverage Financial LeverageFinancial Leverage

What is Leverage?What is Leverage?



2 more concepts that enhance our 2 more concepts that enhance our understanding of risk...understanding of risk...

1) 1) Operating LeverageOperating Leverage - affects a - affects a firm’s business risk.firm’s business risk.

2) 2) Financial LeverageFinancial Leverage - affects a - affects a firm’s financial risk.firm’s financial risk.

Business RiskBusiness Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).



EBIT



FIRMFIRMEBIT



FIRMFIRMEBIT EPS



FIRMFIRMEBIT EPSStock-Stock-holdersholders





Affected by:Affected by: Sales volume variability,Sales volume variability, Competition,Competition, Cost variability,Cost variability, Product diversification,Product diversification, Product demandProduct demand Operating Leverage. Operating Leverage.

Operating LeverageOperating Leverage

The use of The use of fixed operating costsfixed operating costs as as opposed to opposed to variable operating variable operating costs.costs.

A firm with relatively high fixed A firm with relatively high fixed operating costs will experience operating costs will experience more variable operating incomemore variable operating income if if sales change.sales change.

EBIT

OperatingOperatingLeverageLeverage

Financial RiskFinancial Risk

The variability or uncertainty of The variability or uncertainty of a firm’s earnings per share (EPS) a firm’s earnings per share (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..







Financial LeverageFinancial Leverage

The use of The use of fixed-costfixed-cost sources of sources of financing (debt, preferred stock) financing (debt, preferred stock) rather than rather than variable-costvariable-cost sources sources (common stock).(common stock).

EPS

FinancialFinancialLeverageLeverage

Quantity

$Breakeven AnalysisBreakeven Analysis

QuantityQuantity

$$

Total RevenueTotal Revenue

CostsCosts

Suppose the firm has both Suppose the firm has both fixed fixed operating costsoperating costs (administrative (administrative salaries, insurance, rent, property salaries, insurance, rent, property tax) and tax) and variable operating costsvariable operating costs (materials, labor, energy, packaging, (materials, labor, energy, packaging, sales commissions).sales commissions).

QuantityQuantity{{

$$


Total CostTotal Cost

FCFC

QuantityQuantity{{

$$


Total CostTotal Cost

FCFCBreak-Break-

evenevenpointpoint

}EBIT}EBIT

Q1

+

-

Operating LeverageOperating Leverage

What happens if the firm increases What happens if the firm increases its fixed operating costs and reduces its fixed operating costs and reduces (or eliminates) its variable costs?(or eliminates) its variable costs?

QuantityQuantity

{{

$$


Total CostTotal Cost= Fixed= FixedFCFC

Break-Break-evenevenpointpoint

}}QQ11

++

--

EBITEBIT

With high With high operating leverageoperating leverage, , an increase in an increase in salessales

produces a relatively larger produces a relatively larger increase in increase in operating operating

incomeincome..

QuantityQuantity

{{

$$


Total CostTotal Cost= Fixed= FixedFCFC

Break-Break-evenevenpointpoint

}}QQ11

++

--

EBITEBIT

Trade-off: Trade-off: the firm hasthe firm has

a higher breakeven a higher breakeven point. If sales are not point. If sales are not high enough, the firm high enough, the firm will not meet its fixedwill not meet its fixed

expenses!expenses!

Breakeven CalculationsBreakeven Calculations

Breakeven point (units of output)Breakeven point (units of output)

QQBB = = FCFCp – vp – v


Breakeven point (units of output)Breakeven point (units of output)

QQB = B = breakeven level of Q.breakeven level of Q. F = total anticipated fixed costs.F = total anticipated fixed costs. P = sales price per unit.P = sales price per unit. V = variable cost per unit.V = variable cost per unit.

QQBB = = FCFCp - vp - v


S* = S* = FF VCVC SS

1 -1 -

Breakeven point (sales dollars)Breakeven point (sales dollars)

Breakeven point (sales dollars)Breakeven point (sales dollars)

S* = breakeven level of sales.S* = breakeven level of sales. F = total anticipated fixed costs.F = total anticipated fixed costs. S = total sales.S = total sales. VC = total variable costs.VC = total variable costs.


S* = S* = FF VCVC SS

1 -1 -

Analytical Income Analytical Income StatementStatement

SalesSales- variable costsvariable costs-- fixed costs fixed costs operating incomeoperating income-- interest interest EBTEBT-- taxes taxes Net IncomeNet Income



}} contribution margin contribution margin



EBT (1 - t) = Net Income, EBT (1 - t) = Net Income, so,so, Net Income / (1 - t) = EBTNet Income / (1 - t) = EBT

Degree of Operating Degree of Operating Leverage (DOL)Leverage (DOL)

Operating leverage:Operating leverage: by using fixed by using fixed operating costs, a small change in operating costs, a small change in sales revenuesales revenue is magnified into a is magnified into a larger change in larger change in operating incomeoperating income..

This “multiplier effect” is called This “multiplier effect” is called the the degree of operating leveragedegree of operating leverage..

DOLs = DOLs = % change in EBIT% change in EBIT% change in sales% change in sales

Degree of Operating Leverage Degree of Operating Leverage from Sales Level (S)from Sales Level (S)

DOLs = DOLs = % change in EBIT% change in EBIT% change in sales% change in sales

change in EBITchange in EBIT EBITEBITchange in saleschange in sales salessales


=

DOLs = DOLs =


Sales - Variable CostsSales - Variable Costs EBITEBIT

If we have the data, we can use this formula:If we have the data, we can use this formula:

DOLs = DOLs =



Sales - Variable CostsSales - Variable Costs EBITEBIT

Q(p - v) Q(p - v) Q(p - v) - FCQ(p - v) - FC

=

What does this tell us?What does this tell us?

If If DOL = 2DOL = 2, then a , then a 1%1% increase increase in sales will result in a in sales will result in a 2%2% increase in operating income increase in operating income (EBIT).(EBIT).


If If DOL = 2,DOL = 2, then a then a 1%1% increase in increase in sales will result in a sales will result in a 2%2% increase increase in operating income (EBIT).in operating income (EBIT).

Stock-holdersEBIT EPSSales

Degree of Financial Degree of Financial Leverage (DFL)Leverage (DFL)

Financial leverageFinancial leverage: by using fixed : by using fixed cost financing, a small change in cost financing, a small change in operating incomeoperating income is magnified into a is magnified into a larger change in larger change in earnings per shareearnings per share..

This “multiplier effect” is called the This “multiplier effect” is called the degree of financial leverage.degree of financial leverage.

DFL = DFL = % change in EPS% change in EPS% change in EBIT% change in EBIT

Degree of Financial Leverage Degree of Financial Leverage

DFL = DFL = % change in EPS% change in EPS% change in EBIT% change in EBIT

change in EPSchange in EPS EPSEPSchange in EBITchange in EBIT EBITEBIT


=


DFL = DFL = EBIT EBIT EBIT - IEBIT - I


DFL in case where there is DFL in case where there is preferred stockpreferred stock

TPDIEBIT

EBITDFL

1


If If DFL = 3DFL = 3, then a , then a 1%1% increase increase in operating income will result in in operating income will result in a a 3%3% increase in earnings per increase in earnings per share.share.


If If DFL = 3DFL = 3, then a , then a 1%1% increase increase in operating income will result in in operating income will result in a a 3%3% increase in earnings per increase in earnings per share.share.


Degree of Combined Degree of Combined Leverage (DCL)Leverage (DCL)

Combined leverage:Combined leverage: by using by using operating operating leverageleverage and and financial leveragefinancial leverage, a small , a small change in change in salessales is magnified into a larger is magnified into a larger change in change in earnings per shareearnings per share..

This “multiplier effect” is called the This “multiplier effect” is called the degree degree of combined leverage.of combined leverage.

DCL = DOL x DFL DCL = DOL x DFL

% change in EPS% change in EPS% change in Sales% change in Sales

Degree of Combined Leverage Degree of Combined Leverage

==

change in EPSchange in EPS EPSEPSchange in Saleschange in Sales SalesSales

=

DCL = DCL =


Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I


DCL = DCL =


Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I


Q(p - v) Q(p - v) Q(p - v) - FC - IQ(p - v) - FC - I

=

DCL where there is preferred DCL where there is preferred stockstock

TPDIEBIT

CostVariableSalesDFL

1


If If DCL = 4DCL = 4, then a , then a 1%1% increase increase in sales will result in a in sales will result in a 4%4% increase in earnings per share.increase in earnings per share.


If If DCL = 4DCL = 4, then a , then a 1%1% increase increase in sales will result in a in sales will result in a 4%4% increase in earnings per share.increase in earnings per share.


Team Project:Team Project: Based on the following information on Based on the following information on

Levered Company, answer these Levered Company, answer these questions:questions:

1) If 1) If salessales increase by 10%, what should increase by 10%, what should happen to happen to operating incomeoperating income??

2) If 2) If operating incomeoperating income increases by 10%, increases by 10%, what should happen to what should happen to EPSEPS??

3) If 3) If salessales increase by 10%, what should be increase by 10%, what should be the effect on the effect on EPSEPS??

Levered CompanyLevered Company

Sales (100,000 units)Sales (100,000 units) $1,400,000$1,400,000Variable CostsVariable Costs $800,000$800,000Fixed CostsFixed Costs $250,000$250,000Interest paidInterest paid $125,000$125,000Tax rateTax rate 34%34%Common shares outstandingCommon shares outstanding 100,000100,000

LeverageLeverage

SalesSales

EBITEBITEPSEPS

DOL

DFL

DCL


SalesSales

EBITEBITEPSEPS

DOL =DOL =

DFLDFL

DCLDCL


SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL =

DCLDCL


SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL = 1.5561.556

DCLDCL


SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL = 1.5561.556

DCLDCL= 2.667= 2.667

Sales (110,000 units)Sales (110,000 units) 1,540,0001,540,000 Variable CostsVariable Costs (880,000) (880,000) Fixed CostsFixed Costs (250,000)(250,000) EBITEBIT 410,000 410,000 ( +17.14%)( +17.14%) InterestInterest (125,000)(125,000) EBTEBT 285,000 285,000 Taxes (34%)Taxes (34%) (96,900)(96,900) Net IncomeNet Income 188,100 188,100

EPSEPS $1.881 $1.881 ( +26.67%)( +26.67%)

Levered CompanyLevered Company10% increase in sales10% increase in sales

The effect of financial leverageThe effect of financial leverage

The more debt financing a firm uses in its capital structure, the more financial The more debt financing a firm uses in its capital structure, the more financial leverage it employs.leverage it employs.

Illustration:Illustration: CFO is considering a restructuring that would involve issuing debt and using CFO is considering a restructuring that would involve issuing debt and using

the proceeds to buy back some of the outstanding equity. the proceeds to buy back some of the outstanding equity. Firm’s market value = $ 8,000,000Firm’s market value = $ 8,000,000 Shares outstanding = 400,000Shares outstanding = 400,000 When all equity firm, price per share = $ 20When all equity firm, price per share = $ 20 Proposed debt issue would raise $ 4,000,000, interest rate = 10 %Proposed debt issue would raise $ 4,000,000, interest rate = 10 % New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares, New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares,

leaving 2,00,000leaving 2,00,000 New Debt equity ratio = 1New Debt equity ratio = 1 Assume that stock price will remain $20Assume that stock price will remain $20 What is the impact of the proposed restructuring ?What is the impact of the proposed restructuring ?

Illustration (contd…)Illustration (contd…)Current Capital Structure: No debt

Recession Expected ExpansionEBIT $ 5,00,000 $ 1,000,000 $ 1,500,000Interest 0 0 0Net Income $ 5,00,000 $ 1,000,000 $ 1,500,000ROE 6.25 % 12.50 % 18.75 %EPS $ 1.25 $ 2.50 $ 3.75

Proposed Capital Structure: Debt = $ 4,000,000EBIT $ 500,000 $ 1,000,000 $ 1,500,000Interest 400,000 400,000 400,000Net Income $ 100,000 $ 600,000 $ 1,100,000ROE 2.50 % 15.00 % 27.50 %EPS $ 0.50 $ 3.00 $ 5.50

Illustration (contd…)Illustration (contd…)

• In no debt case, every $ 400,000 increase in EBIT increases EPS by $ 1

• In proposed capital structure, every $ 400,000 increase in EBIT increases EPS by $ 2

•Breakeven point is indifference point.

•If EBIT is above this level, leverage is beneficial, otherwise not.

Economy & Finance

Operating Leverage - Finacial leverage & Break-Even