Breakeven and Financial Leverage

By R. S. Miolla

Capital Structure

• The firm’s mixture of debt versus equity• Shows how the firm has financed assets• A = L + OE• A firm should establish a target capital

structure. Ex: 100% = 40% + 60%.

Cost Behavior

• Fixed Costs – Costs that do not vary with sales. Ex: leases, depreciation, property taxes, salaries

• Variable Costs – Costs that vary in direct proportion to sales. Ex: raw materials, factory labor, sales commissions

• Semi-Variable Costs – A mix. Ex: utilities, repairs and maintenance.

Breakeven Analysis

• VCPU: variable cost per unit• Price: selling price of your product• Fixed Costs: total fixed costs for a time period• Computes NUMBER of units

• Breakeven Volume (#) = Fixed Costs• Price – VCPU

Breakeven Example

• Fixed Costs = $60,000• Sell a cup of coffee for $2.00• VCPU = $.80• BE = 60,000 = 50,000 UNITS

• 2 - .80

Degree of Financial Leverage

• The key is how the firm is capitalized – how much debt versus equity

• DFL= % change in EPS% change in Operating Profit

• Impacts how risky the firm is.• High DFL: Leveraged• Low DFL: Conservative

DFL

• The more debt the firm has, the higher the DFL will be.

• DFL = Operating ProfitOperating Profit - Interest

• Interest = interest expense

DFL Example

• Leveraged – Operating profit = 50,000; Interest = 25,000– DFL= 50,000/(50,000 – 25,000)– DFL = 2

• Conservative – Operating profit = 50,000 Interest = 5,000 (less debt)– DFL = 50,000/(50,000 – 5,000)– DFL = 1.1

Price to Earnings Ratio

• Called P/E ratio• P/E = Market Price of a Stock

EPS from most current year

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