215 Chap05 Leverage
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Transcript of 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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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 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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McGraw-Hill/Irwin 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
FIGURE 5-1Break-even
chart:
Leveragedfirm
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McGraw-Hill/Irwin 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
TABLE 5-5Impact ofFinancing plan on earnings/share
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
TABLE 5-5Impact ofFinancing plan on earnings/share
Earnings before Interest and taxes (EBIT)= $16,000.00
Plan A
(Leveraged)
Plan B
( onservative)
Earnings before Interest and taxes (EBIT) $16,000 $16,000
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
TABLE 5-5Impact ofFinancing plan on earnings/share
Earnings before Interest and taxes (EBIT)= $36,000.00
Plan A
(Leveraged)
Plan B
(Conservative)
Earnings before Interest and taxes (EBIT) $36,000 $36,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $24,000 $32,000
Less Taxes (T) (assume 50%) ($12,000) ($16,000)
equals Earnings Before Taxes (EBT) $12,000 $16,000
divided by No. of Shares Outstanding $8,000 $24,000equals Earnings Per Share (EPS) $1.500 $0.667
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5-8
TABLE 5-5Impact ofFinancing plan on earnings/share
Earnings before Interest and taxes (EBIT)= $60,000.00
Plan A
(Leveraged)
Plan B
(Conservative)
Earnings before Interest and taxes (EBIT) $60,000 $60,000
Less Interest Payments (I) ($12,000) ($4,000)
equals Earnings Before Taxes (EBT) $48,000 $56,000
Less Taxes (T) (assume 50%) ($24,000) ($28,000)
equals Earnings Before Taxes (EBT) $24,000 $28,000
divided by No. of Shares Outstanding $8,000 $24,000equals Earnings Per Share (EPS) $3.000 $1.167
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TABLE 5-5Impact ofFinancing plan on earnings/share
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