0273685988 Ch16

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Chapter 16Chapter 16

Operating and Operating and Financial LeverageFinancial Leverage


© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI

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After studying Chapter 16, After studying Chapter 16, you should be able to:you should be able to:

Define operating and financial leverage and identify causes of both.

Calculate a firm’s operating break-even (quantity) point and break-even (sales) point .

Define, calculate, and interpret a firm's degree of operating, financial, and total leverage.

Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart.

Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk.”

Understand what is involved in determining the appropriate amount of financial leverage for a firm.

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Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods

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Operating LeverageOperating Leverage

One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss).

Operating Leverage Operating Leverage -- The use of -- The use of fixed operating costs by the firm.fixed operating costs by the firm.

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Impact of Operating Impact of Operating Leverage on ProfitsLeverage on Profits

Firm F Firm V Firm 2FFirm F Firm V Firm 2F

Sales $10 $11 $19.5Operating Costs

Fixed 7 2 14 Variable 2 7 3Operating Profit $$ 11 $ 2$ 2 $ 2.5 $ 2.5

FC/total costs .78 .22 .82 FC/sales .70 .18 .72

(in thousands)(in thousands)

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Now, subject each firm to a 50% 50% increase in sales increase in sales for next year.

Which firm do you think will be more “sensitive” “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)?

[ ] Firm FFirm F; [ ] Firm VFirm V; [ ] Firm 2FFirm 2F.

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Firm F Firm V Firm 2FFirm F Firm V Firm 2F

Sales $15 $16.5 $29.25Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5Operating Profit $$ 55 $ 4 $ 4 $10.75 $10.75

PercentagePercentage Change in EBITChange in EBIT* 400% 100% 330%400% 100% 330%

(in thousands)(in thousands)

* (EBITt - EBIT t-1) / EBIT t-1

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Firm F Firm F is the most “sensitive” firm is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT400% increase in EBIT.

Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage.

Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage.

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Break-Even AnalysisBreak-Even Analysis

When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments.

Break-Even Analysis Break-Even Analysis -- A technique for studying the relationship among fixed

costs, variable costs, sales volume, and profitsprofits. Also called cost/volume/profit

(C/V/P) analysis.

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Break-Even ChartBreak-Even Chart

QUANTITY PRODUCED AND SOLDQUANTITY PRODUCED AND SOLD

0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000

Total RevenuesTotal Revenues

ProfitsProfits

Fixed CostsFixed Costs

Variable CostsVariable CostsLossesLosses

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Break-Even Break-Even (Quantity) Point(Quantity) Point

How to find the quantity break-even point:

EBIT = PP(QQ) - VV(QQ) - FCFC EBIT = QQ(PP - VV) - FCFC

P = Price per unitP = Price per unit V = Variable costs per unitV = Variable costs per unit FC = Fixed costs FC = Fixed costs Q = Quantity (units) Q = Quantity (units)

produced and soldproduced and sold

Break-Even Point Break-Even Point -- The sales volume required -- The sales volume required so that total revenues and total costs are so that total revenues and total costs are equal; may be in units or in sales dollars.equal; may be in units or in sales dollars.

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Break-Even Break-Even (Quantity) Point(Quantity) Point

Breakeven occurs when EBIT = 0

Q Q (PP - VV) - FCFC = EBIT

QQBE BE (PP - VV) - FCFC = 0

QQBE BE (PP - VV) = FCFC

QQBEBE = FCFC / (PP - VV) a.k.a. Unit Contribution Margin

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Break-Even (Sales) PointBreak-Even (Sales) Point

How to find the sales break-even point:

SSBEBE = FCFC + (VCVCBEBE)

SSBEBE = FC FC + (QQBEBE )(VV)

or

SSBE BE ** = FCFC / [1 - (VCVC / S) ]

* Refer to text for derivation of the formula

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Break-Even Break-Even Point ExamplePoint Example

Basket Wonders (BW) wants to determine both the quantity and sales quantity and sales

break-even points break-even points when: Fixed costs Fixed costs are $100,000$100,000

Baskets are sold for $43.75$43.75 eacheach

Variable costs are $18.75 per basket$18.75 per basket

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Break-Even Point (s)Break-Even Point (s)

Breakeven occurs when:

QQBEBE = FCFC / (PP - VV)

QQBEBE = $100,000$100,000 / ($43.75$43.75 - $18.75$18.75)

QQBEBE = 4,000 Units4,000 Units

SSBEBE = (QQBEBE )(VV) + FCFC

SSBEBE = (4,0004,000 )($18.75$18.75) + $100,000$100,000

SSBEBE = $175,000$175,000

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Break-Even ChartBreak-Even Chart


0 1,000 2,000 3,000 4,0004,000 5,000 6,000 7,000

Total RevenuesTotal Revenues

ProfitsProfits

Fixed CostsFixed Costs

Variable CostsVariable CostsLossesLosses

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

DOLDOL at Q units of output

(or sales)

Degree of Operating Leverage Degree of Operating Leverage -- The percentage change in a firm’s operating profit (EBIT) resulting from a 1 percent

change in output (sales).

=

Percentage change in operating profit (EBIT)

Percentage change in output (or sales)

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Computing the DOLComputing the DOL

DOLDOLQ unitsQ units

Calculating the DOL for a single product Calculating the DOL for a single product or a single-product firm.or a single-product firm.

=QQ (PP - VV)

QQ (PP - VV) - FCFC

= QQ

QQ - QQBEBE

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Computing the DOLComputing the DOL

DOLDOLS dollars of salesS dollars of sales

Calculating the DOL for a Calculating the DOL for a multiproduct firm.multiproduct firm.

=SS - VCVC

SS - VCVC - FCFC

=EBIT + FCFC

EBIT

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Break-Even Break-Even Point ExamplePoint Example

Lisa Miller wants to determine the degree degree of operating leverage of operating leverage at sales levels of sales levels of

6,000 and 8,000 units6,000 and 8,000 units. As we did earlier, we will assume that:

Fixed costs Fixed costs are $100,000$100,000



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Computing BW’s DOLComputing BW’s DOL

DOLDOL6,000 units6,000 units

Computation based on the previously Computation based on the previously calculated break-even point of 4,000 unitscalculated break-even point of 4,000 units

=6,0006,000

6,000 6,000 - 4,000 4,000

=

= 33

DOLDOL8,000 units8,000 units

8,0008,0008,000 8,000 - 4,000 4,000

= 22

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Interpretation of the DOLInterpretation of the DOL

A 1% increase in sales above the 8,000 A 1% increase in sales above the 8,000 unit level increases EBIT by 2% unit level increases EBIT by 2%

because of the existing operating because of the existing operating leverage of the firm.leverage of the firm.

=DOLDOL8,000 units8,000 units

8,0008,0008,000 8,000 - 4,000 4,000

= 22

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2,000 2,000 4,0004,000 6,000 8,000 6,000 8,000

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DOL is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales.

The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL.

When comparing firms, the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales.

Key Conclusions to be Drawn from the Key Conclusions to be Drawn from the previous slide and our Discussion of DOLprevious slide and our Discussion of DOL

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DOL and Business RiskDOL and Business Risk

DOL is only one component one component of business risk and becomes “active” only in the presence only in the presence of sales and production cost variabilityof sales and production cost variability.

DOL magnifiesmagnifies the variability of operating profits and, hence, business risk.

Business Risk Business Risk -- The inherent uncertainty -- The inherent uncertainty in the physical operations of the firm. Its in the physical operations of the firm. Its impact is shown in the variability of the impact is shown in the variability of the

firm’s operating income (EBIT).firm’s operating income (EBIT).

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Application of DOL for Application of DOL for Our Three Firm ExampleOur Three Firm Example

Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm FFirm F::

DOLDOL = [( = [(EBITEBIT + + FCFC)/)/EBITEBIT]]

=DOLDOL$10,000 sales$10,000 sales

1,000 1,000 ++ 7,0007,0001,0001,000

= 8.08.0

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Application of DOL for Application of DOL for Our Three Firm ExampleOur Three Firm Example

Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm VFirm V::



2,000 2,000 ++ 2,0002,0002,0002,000

= 2.02.0

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Application of DOL for Application of DOL for Our Three-Firm ExampleOur Three-Firm Example

Use the data in Slide 16-5 and the Use the data in Slide 16-5 and the following formula for following formula for Firm 2FFirm 2F::



2,500 2,500 ++ 14,00014,0002,5002,500

= 6.66.6

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Application of DOL for Application of DOL for Our Three-Firm ExampleOur Three-Firm Example

The ranked results indicate that the firm most The ranked results indicate that the firm most sensitive to the presence of operating leverage sensitive to the presence of operating leverage

is is Firm FFirm F.

Firm FFirm F DOLDOL = = 8.08.0Firm VFirm V DOLDOL = = 6.66.6Firm 2FFirm 2F DOLDOL = = 2.02.0

Firm FFirm F will expect a will expect a 400% increase in profit400% increase in profit from a from a 50% 50% increase in salesincrease in sales (see Slide 16-7 results). (see Slide 16-7 results).

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Financial LeverageFinancial Leverage

Financial leverage is acquired by choice.

Used as a means of increasing the return to common shareholders.

Financial Leverage Financial Leverage -- The use of -- The use of fixed financing costs by the firm. fixed financing costs by the firm. The British expression is The British expression is gearinggearing..

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EBIT-EPS Break-Even, EBIT-EPS Break-Even, or Indifference, Analysisor Indifference, Analysis

Calculate EPS EPS for a given level of EBITEBIT at a given financing structure.

EBIT-EPS Break-Even Analysis EBIT-EPS Break-Even Analysis -- Analysis -- Analysis of the effect of financing alternatives on of the effect of financing alternatives on

earnings per share. The break-even point is earnings per share. The break-even point is the EBIT level where EPS is the same for the EBIT level where EPS is the same for

two (or more) alternatives.two (or more) alternatives.

(EBITEBIT - I) (1 - t) - Pref. Div.

# of Common SharesEPSEPS =

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EBIT-EPS ChartEBIT-EPS Chart

Current common equity shares = 50,000Current common equity shares = 50,000 $1 million in new financing of either:$1 million in new financing of either:

All C.S. sold at $20/share (50,000 shares) All debt with a coupon rate of 10% All P.S. with a dividend rate of 9%

Expected EBIT = $500,000Expected EBIT = $500,000 Income tax rate is 30%Income tax rate is 30%

Basket Wonders Basket Wonders has $2 million in LT financing has $2 million in LT financing (100% common stock equity).(100% common stock equity).

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EBIT-EPS Calculation with EBIT-EPS Calculation with New Equity FinancingNew Equity Financing

EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 0 0EACS EACS $350,000 $350,000 $105,000 $105,000# of Shares 100,000 100,000EPSEPS $3.50 $3.50 $1.05 $1.05

Common Stock Equity AlternativeCommon Stock Equity Alternative

* A second analysis using $150,000 EBIT rather than the expected EBIT.

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0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700

EBIT ($ thousands)EBIT ($ thousands)

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EBIT-EPS Calculation with EBIT-EPS Calculation with New Debt FinancingNew Debt Financing

EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 100,000 100,000EBT $400,000 $ 50,000Taxes (30% x EBT) 120,000 15,000EAT $280,000 $ 35,000Preferred Dividends 0 0EACS EACS $280,000 $280,000 $ 35,000 $ 35,000# of Shares 50,000 50,000EPSEPS $5.60 $5.60 $0.70 $0.70

Long-term Debt AlternativeLong-term Debt Alternative


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0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700


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CommonCommon

DebtDebt

Indifference pointbetween debtdebt and

common stockcommon stockfinancing

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EBIT-EPS Calculation with EBIT-EPS Calculation with New Preferred FinancingNew Preferred Financing

EBITEBIT $500,000 $500,000 $150,000 $150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000EAT $350,000 $105,000Preferred Dividends 90,000 90,000EACS EACS $260,000 $260,000 $ 15,000 $ 15,000# of Shares 50,000 50,000EPSEPS $5.20 $5.20 $0.30 $0.30

Preferred Stock AlternativePreferred Stock Alternative


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0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700



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Indifference pointbetween preferred preferred stock stock and common common

stockstock financing

PreferredPreferred

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What About Risk?What About Risk?

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Lower riskLower risk. Only a smallprobability that EPS willbe less if the debtalternative is chosen.

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What About Risk?What About Risk?

0 100 200 300 400 500 600 7000 100 200 300 400 500 600 700


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DebtDebt

Higher riskHigher risk. A much largerprobability that EPS willbe less if the debtalternative is chosen.

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

DFLDFL at EBIT of

X dollars

Degree of Financial Leverage Degree of Financial Leverage -- The percentage change in a firm’s earnings

per share (EPS) resulting from a 1 percent change in operating profit.

=

Percentage change in earnings per share (EPS)

Percentage change in operating profit (EBIT)

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Computing the DFLComputing the DFL

DFLDFL EBIT of $X

Calculating the DFLCalculating the DFL

=EBITEBIT

EBIT EBIT - II - [ PDPD / (1 - tt) ]

EBIT EBIT = Earnings before interest and taxes= Earnings before interest and taxesI I = Interest= InterestPD PD = Preferred dividends= Preferred dividendst t = Corporate tax rate= Corporate tax rate

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What is the DFL for Each What is the DFL for Each of the Financing Choices?of the Financing Choices?

DFLDFL $500,000$500,000

Calculating the DFL for Calculating the DFL for NEWNEW equity equity* alternativealternative

=$500,000$500,000

$500,000 $500,000 - 00 - [00 / (1 - 00)]

* The calculation is based on the expected EBIT

= 1.001.00

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DFLDFL $500,000$500,000

Calculating the DFL for Calculating the DFL for NEWNEW debt debt * alternativealternative

=$500,000$500,000

{{ $500,000 $500,000 - 100,000100,000 - [00 / (1 - 00)] }


= $500,000$500,000 / $400,000

1.251.25=

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DFLDFL $500,000$500,000

Calculating the DFL for Calculating the DFL for NEWNEW preferred preferred * alternativealternative

=$500,000$500,000

{{ $500,000 $500,000 - 0 0 - [90,00090,000 / (1 - .30.30)] }


= $500,000$500,000 / $400,000

1.351.35=

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Variability of EPSVariability of EPS

Preferred stock Preferred stock financing will lead to the greatest variability in earnings per share based on the DFL.

This is due to the tax deductibility of interest on debt financing.

DFLDFLEquityEquity = 1.00 = 1.00

DFLDFLDebtDebt = 1.25 = 1.25

DFLDFLPreferredPreferred = = 1.351.35

Which financing method will have

the greatest relative greatest relative variability in EPS?variability in EPS?

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Financial RiskFinancial Risk

Debt increases the probability of cash insolvency over an all-equity-financed firm. For example, our example firm must have EBIT of at least $100,000 to cover the interest payment.

Debt also increased the variability in EPS as the DFL increased from 1.00 to 1.25.

Financial Risk Financial Risk -- The added variability in -- The added variability in earnings per share (EPS) -- plus the risk of earnings per share (EPS) -- plus the risk of

possible insolvency -- that is induced by the possible insolvency -- that is induced by the use of financial leverage.use of financial leverage.

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Total Firm RiskTotal Firm Risk

CVCVEPSEPS is a measure of relative total firm risktotal firm risk

CVCVEBITEBIT is a measure of relative business riskbusiness risk

The difference, CVCVEPSEPS - CV - CVEBITEBIT, is a measure of relative financial riskfinancial risk

Total Firm Risk Total Firm Risk -- The variability in earnings per -- The variability in earnings per share (EPS). It is the sum of business plus share (EPS). It is the sum of business plus

financial risk.financial risk.

Total firm risk Total firm risk = business risk business risk + financial riskfinancial risk

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Degree of Total Degree of Total Leverage (DTL)Leverage (DTL)

DTLDTL at Q units (or S dollars) of output (or

sales)

Degree of Total Leverage Degree of Total Leverage -- The percentage change in a firm’s earnings

per share (EPS) resulting from a 1 percent change in output (sales).

=

Percentage change in earnings per share (EPS)

Percentage change in output (or sales)

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Computing the DTLComputing the DTL

DTLDTL S dollars

of sales

DTLDTL Q units (or S dollars) Q units (or S dollars) = ( DOL DOL Q units (or S dollars) Q units (or S dollars) ) x ( DFLDFL EBIT of X dollars EBIT of X dollars )

=EBITEBIT + FC

EBIT EBIT - II - [ PDPD / (1 - tt) ]

DTLDTL Q unitsQQ (PP - - VV)

QQ (PP - - VV) - FC - II - [ PDPD / (1 - tt) ]=

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DTL ExampleDTL Example

Lisa Miller wants to determine the Degree of Total Leverage Degree of Total Leverage at

EBIT=$500,000. EBIT=$500,000. As we did earlier, we will assume that:

Fixed costs Fixed costs are $100,000$100,000



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Computing the DTL Computing the DTL for All-Equity Financingfor All-Equity Financing

DTLDTL S dollars

of sales

=$500,000$500,000 + $100,000

$500,000 $500,000 - 00 - [ 00 / (1 - .3.3) ]

DTLDTLS dollars S dollars = (DOLDOL S dollars S dollars) x (DFLDFLEBIT of $S EBIT of $S )

DTLDTLS dollars S dollars = (1.2 1.2 ) x ( 1.01.0* ) = 1.201.20

= 1.201.20*Note: No financial leverage.

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Computing the DTL Computing the DTL for Debt Financingfor Debt Financing

DTLDTL S dollars

of sales

=$500,000$500,000 + $100,000

{ $500,000 $500,000 - $100,000$100,000 - [ 00 / (1 - .3.3) ] }

DTLDTLS dollars S dollars = (DOLDOL S dollars S dollars) x (DFLDFLEBIT of $S EBIT of $S )

DTLDTLS dollars S dollars = (1.2 1.2 ) x ( 1.251.25* ) = 1.501.50

= 1.501.50*Note: Calculated on Slide 16-44.

16-54

Risk versus ReturnRisk versus Return

Compare the expected EPS to the DTL for the common stock equity financing

approach to the debt financing approach.

FinancingFinancing E(EPS)E(EPS) DTLDTL

EquityEquity $3.50$3.50 1.201.20 DebtDebt $5.60$5.60 1.501.50

Greater expected return (higher EPS) comes at Greater expected return (higher EPS) comes at the expense of greater potential risk (higher DTL)!the expense of greater potential risk (higher DTL)!

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What is an Appropriate What is an Appropriate Amount of Financial Leverage?Amount of Financial Leverage?

Firms must first analyze their expected future expected future cash flows.cash flows.

The greater greater and more stable more stable the expected future cash flows, the greater the debt capacity.the greater the debt capacity.

Fixed charges includeFixed charges include: debt principal and interest payments, lease payments, and preferred stock dividends.

Debt Capacity Debt Capacity -- The maximum amount of debt -- The maximum amount of debt (and other fixed-charge financing) that a firm (and other fixed-charge financing) that a firm

can adequately service.can adequately service.

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Coverage RatiosCoverage RatiosCoverage RatiosCoverage Ratios

Interest CoverageInterest Coverage

EBITEBITInterest expensesInterest expenses

Interest CoverageInterest Coverage

EBITEBITInterest expensesInterest expenses

Indicates a firm’s ability to cover

interest charges.

Income StatementRatios

Coverage Ratios

A ratio value equal to 1indicates that earnings

are just sufficient tocover interest charges.

16-57

Coverage RatiosCoverage RatiosCoverage RatiosCoverage Ratios

Debt-service CoverageDebt-service Coverage

EBITEBIT{ Interest expensesInterest expenses +

[Principal payments / (1-t) Principal payments / (1-t) ] }

Debt-service CoverageDebt-service Coverage

EBITEBIT{ Interest expensesInterest expenses +

[Principal payments / (1-t) Principal payments / (1-t) ] }

Indicates a firm’s ability to cover

interest expenses and principal payments.

Income StatementRatios

Coverage Ratios

Allows us to examine theability of the firm to meetall of its debt payments.Failure to make principalpayments is also default.

16-58

Coverage ExampleCoverage Example

Make an examination of the coverage coverage ratiosratios for Basket Wonders when

EBIT=$500,000. EBIT=$500,000. Compare the equity and the debt financing alternatives.

Assume thatAssume that: Interest expensesInterest expenses remain at $100,000$100,000

Principal payments of $100,000Principal payments of $100,000 are made yearly for 10 years

16-59


Compare the interest coverage and debt burden ratios for equity and debt financing.

Interest Interest Debt-service Debt-service FinancingFinancing CoverageCoverage Coverage Coverage

EquityEquity Infinite Infinite Infinite Infinite DebtDebt 5.00 5.00 2.50 2.50The firm actually has greater risk than the interest The firm actually has greater risk than the interest

coverage ratio initially suggests.coverage ratio initially suggests.

16-60


-250 0 250 500 750 1,000 1,250-250 0 250 500 750 1,000 1,250


Firm B has a much smaller probability

of failing to meet its obligations than Firm A.

Firm BFirm B

Firm AFirm A

Debt-service burdenDebt-service burden= $200,000= $200,000

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Summary of the Coverage Summary of the Coverage Ratio DiscussionRatio DiscussionSummary of the Coverage Summary of the Coverage Ratio DiscussionRatio Discussion

A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.

Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt.

A single ratio value cannot be interpreted identically for all firms as some firms have greater debt capacity.

Annual financial lease payments should be added to both the numerator and denominator of the debt-service coverage ratio as financial leases are similar to debt.

The debt-service coverage ratio accounts for required annual principal payments.

The debt-service coverage ratio accounts for required annual principal payments.

16-62

Other Methods of AnalysisOther Methods of Analysis

Often, firms are compared to peer institutions in the same industry.

Large deviations from norms must be justified.

For example, an industry’s median debt-to-net-worth ratio might be used as a benchmark for financial leverage comparisons.

Capital Structure Capital Structure -- The mix (or proportion) of a -- The mix (or proportion) of a firm’s permanent long-term financing firm’s permanent long-term financing

represented by debt, preferred stock, and represented by debt, preferred stock, and common stock equity.common stock equity.

16-63


Firms may gain insight into the financial markets’ evaluation of their firm by talking with:

Investment bankers Institutional investors Investment analysts Lenders

Surveying Investment Analysts and LendersSurveying Investment Analysts and Lenders

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Firms must consider the impact of any financing decision on the firm’s security rating(s).

Security RatingsSecurity Ratings

0273685988 Ch16

Business

Transcript of 0273685988 Ch16