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
end
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