Sld05 Operating and Fin Leverage

CHAPTER
FIVE
Operating and
Financial Leverage
McGraw-Hill Ryerson
McGraw-Hill Ryerson Limited 2000
FIF T H
Foundations of Financial
Management
th
CANADIAN
PPT 5-1
EDI TI ON
Figure 5-1
Break-even chart: Leveraged firm
Total
Revenue
Revenues and costs ($ thousands)

200
Profit
160
120
100
80
60
40
BE
Variable costs
Loss
20
Block
Hirt
Short
Total
costs
Fixed
costs
40
50
60
80
100
120
Units produced and sold (thousands)

Fixed costs ($60,000)
Price ($2) Variable costs per unit ($0.80)
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EDI TI ON
Table 5-2
Volume-cost-profit analysis: Leveraged firm
Units
Sold
Total
Variable
Costs
0
0
20,000 $16,000
40,000 32,000
50,000 40,000
60,000 48,000
80,000 64,000
100,000 80,000
Fixed
Costs
$ 60,000
60,000
60,000
60,000
60,000
60,000
60,000
Total
Costs
$ 60,000
76,000
92,000
100,000
108,000
124,000
140,000
Total
Revenue
0
$ 40,000
80,000
100,000
120,000
160,000
200,000
Operating
Income
(loss)
$ (60,000)
(36,000)
(12,000)
0
12,000
36,000
60,000
Block
Hirt
Short
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Management
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PPT 5-3
EDI TI ON
Figure 5-2
Break-even chart: Conservative firm
Total
Revenue

200
Profit
Total
costs
160
120
80
40
BE
20
Loss
Block
Hirt
Short
Variable costs
40
60
80
100
120
Fixed
costs
Units produced and sold (thousands)

Fixed costs ($12,000) Price ($2) Variable costs per unit ($1.60)
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PPT 5-4
EDI TI ON
Table 5-3
Volume-cost-profit analysis: Conservative firm
Units
Sold
0
20,000
30,000
40,000
60,000
80,000
100,000
Total
Variable
Costs
0
$ 32,000
48,000
64,000
96,000
128,000
160,000
Fixed
Costs
Total
Costs
$ 12,000
$12,000
12,000
12,000
12,000
12,000
12,000
12,000
44,000
60,000
76,000
108,000
140,000
172,000
Operating
Total
Income
Revenue
(loss)
0
$ 40,000
60,000
80,000
120,000
160,000
200,000
$ (12,000)
(4,000)
0
4,000
12,000
20,000
28,000
.
Block
Hirt
Short
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PPT 5-5
EDI TI ON
Table 5-4
Operating income or loss
Leveraged
Firm
(Table 5-2)
Units
0
20,000
40,000
60,000
80,000
100,000
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
$(60,000)
(36,000)
(12,000)
12,000
36,000
60,000
Conservative
Firm
(Table 5-3)
$(12,000)
(4,000)
4,000
12,000
20,000
28,000
Block
Hirt
Short
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Figure 5-3
Nonlinear break-even analysis
Revenue
weakness

200
160
Total
revenue
Cost
overruns
120
80
Total
costs
40
120
Block
Hirt
Short
20
40 area 60
Valid
80
100
Units (thousands)
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Table 5-5a
Impact of financing plan on earnings per share
Plan A
(leveraged)
Block
Hirt
Short
PPT 5-7
1. EBIT (0)
Earnings before interest and taxes (EBIT)
Interest (I)
Earnings before taxes (EBT)
Taxes (T) *
Earnings aftertaxes(EAT)
Shares
Earnings per share (EPS)
2. EBIT ($12,000)
Interest (I)
Taxes (T)
Earnings aftertaxes (EAT)
Shares
Plan B
(conservative)
0
$(12,000)
(12,000)
(6,000)
$ (6,000)
8,000
$ (0.75)
$ (4,000)
(4,000)
(2,000)
$ (2,000)
24,000
$ (0.08)
$12,000
12,000
0
0
$
0
8,000
0
$12,000
4,000
8,000
4,000
$ 4,000
24,000
$0.17
0
.
* The assumption is that large losses can be written off against other income, perhaps in other years,
thus providing the firm with a tax savings benefit. The tax rate is 50 percent for ease of computation.
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PPT 5-7
EDI TI ON
Table 5-5b
Plan A
(leveraged)
Plan B
(conservative)
3. EBIT ($16,000)
Interest (I)
Taxes (T)
Shares
$ 16,000
12,000
4,000
2,000
$ 2,000
8,000
$0.25
$ 16,000
4,000
12,000
6,000
$ 6,000
24,000
$0.25
4. EBIT ($36,000)
Interest (I)
Taxes (T)
Shares
$ 36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
$ 36,000
4,000
32,000
16,000
$ 16,000
24,000
$0.67
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Table 5-5c
5. EBIT ($60,000)
Interest (I)
Taxes (T)
Shares
Plan A
(leveraged)
Plan B
(conservative)
$ 60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
$ 60,000
4,000
56,000
28,000
$ 28,000
24,000
$ 1.17
Block
Hirt
Short
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EDI TI ON
Figure 5-4
Financing plans and earnings per share
EPS ($)
4
Plan A
3
2
Plan B
1
.25
0
-1
Block
Hirt
Short
-2
0
McGraw-Hill Ryerson
12
16
25
50
75
EBIT ($ thousands)
100
FIF T H
Management
th
CANADIAN
PPT 5-9
EDI TI ON
Figure 5-5
Financial leverage in selected industries (third quarter, 1998)
Total debt / equity
Long-term debt / equity
8.00
7.00
Ratio
6.00
5.00
4.00
3.00
2.00
Tele communications
Re al estate
Electronics,
computers
Motor vehicles
Machinery,
equipment
Chemical, te xtile s
Pe trole um, natural

gas
Wood, paper
Food
Beve rage, tobacco
Block
Hirt
Short
All nonfinancial
0.00
All industries
1.00
Source : Sta tistics Ca na da , Quarte rly Financia l S ta tistics for Ente rprise s, Ca talogue 61-008
XPB, third qua rte r, 1998.
McGraw-Hill Ryerson
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Foundations of Financial PPT 5-10

Management
th
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Table 5-6
Income statement
Sales (total revenue) (80,000 units @ $2)
Fixed costs
Variable costs ($0.80 per unit)
Operating income
Earnings before interest and taxes
Interest
Earnings before taxes
Taxes
Earnings aftertaxes
Shares
Earnings per share
$160,000
60,000
64,000
$ 36,000
$ 36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
Operating
leverage
Financial
leverage
Block
Hirt
Short
McGraw-Hill Ryerson
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th
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Figure 5-6
Combining operating and financial leverage
$
Earnings generated
EPS =
$1.50
Financial
leverage
Operating income = EBIT

$36,000
$36,000
Operating
leverage
Block
Hirt
Short
Sales =
$160,000
Leverage impact
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Table 5-7
Operating and financial leverage
(Taken from Table 5-6)
(80,000 units)
Sales $2 per unit
Fixed costs
Variable costs ($0.80 per unit)
Operating income (EBIT)
Interest
Earnings before taxes
Taxes
Earnings aftertaxes
Shares
Earnings per share
$160,000
60,000
64,000
36,000
12,000
24,000
12,000
$ 12,000
8,000
$1.50
(100,000 units)
$200,000
60,000
80,000
60,000
12,000
48,000
24,000
$ 24,000
8,000
$3.00
Block
Hirt
Short
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Chapter 5 - Outline
LT 5-1
What is Leverage?
Operating Leverage
Financial Leverage
Leverage Means Risk
Block
Hirt
Short
Combined or Total Leverage

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What is Leverage?
LT 5-2
Leverage is using fixed costs to magnify the potential

return to a firm
2 types of fixed costs:
fixed operating costs = rent, amortization
fixed financial costs = interest costs from debt
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Operating Leverage
LT 5-3
Measure of the amount of fixed operating costs used by a

firm
Operating Leverage measures the sensitivity of a firms
operating income to a in sales
a in Sales a larger in EBIT (or OI)
Block
Hirt
Short
Degree of Operating Leverage (DOL)

= %age in EBIT ( or OI)
%age in Sales
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Management
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Financial Leverage
LT 5-4
Measure of the amount of debt used and interest paid by a

firm
Financial Leverage measures the sensitivity of a firms
earnings per share to a in operating income
a in EBIT (or OI) a larger in EPS
Block
Hirt
Short
Degree of Financial Leverage (DFL)

= %age in EPS
%age in EBIT (or OI)
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Leverage Means Risk
LT 5-5
Leverage is a double-edged sword

It magnifies losses as well as profits
An aggressive or highly leveraged firm has a relatively
high break-even point (and high fixed costs)
A conservative or non-leveraged firm has a relatively low
break-even point (and low fixed costs)
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Combined or Total Leverage
LT 5-6
Represents maximum use of leverage

a in Sales a larger in EPS
Degree of Combined Leverage (DCL ) = %age in EPS
%age in Sales
Short-cut formula:
DCL = DOL x DFL
Block
Hirt
Short
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CHAPTER

McGraw-Hill Ryerson Limited 2000

Revenues and costs ($ thousands)

Units produced and sold (thousands)

McGraw-Hill Ryerson Limited 2000

McGraw-Hill Ryerson Limited 2000

Revenues and costs ($ thousands)

Units produced and sold (thousands)

McGraw-Hill Ryerson Limited 2000

McGraw-Hill Ryerson Limited 2000

McGraw-Hill Ryerson Limited 2000

Revenues and costs ($ thousands)

McGraw-Hill Ryerson Limited 2000

McGraw-Hill Ryerson Limited 2000

McGraw-Hill Ryerson Limited 2000

Long-term debt / equity

Pe trole um, natural

Beve rage, tobacco

McGraw-Hill Ryerson Limited 2000

Foundations of Financial PPT 5-10

McGraw-Hill Ryerson Limited 2000

Foundations of Financial PPT 5-11

Operating income = EBIT

McGraw-Hill Ryerson Limited 2000

Foundations of Financial PPT 5-12

McGraw-Hill Ryerson Limited 2000

Combined or Total Leverage

McGraw-Hill Ryerson Limited 2000

Leverage is using fixed costs to magnify the potential

McGraw-Hill Ryerson Limited 2000

Measure of the amount of fixed operating costs used by a

Degree of Operating Leverage (DOL)

McGraw-Hill Ryerson Limited 2000

Measure of the amount of debt used and interest paid by a

Degree of Financial Leverage (DFL)

McGraw-Hill Ryerson Limited 2000

Leverage Means Risk

Leverage is a double-edged sword

McGraw-Hill Ryerson Limited 2000

Combined or Total Leverage

Represents maximum use of leverage

McGraw-Hill Ryerson Limited 2000

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