Professor Crocker H.

Liu

Crocker H. Liu, Stern School of Business, NYU

Leverage: It Comes in Two Flavors

Combined Leverage

% Sales

% EBIT

% EPS

Operating Leverage: The use of fixed operating costs in the operating (cost/expense) structure

Financial Leverage: The use of fixed financing cost (debt) in the capital structure

Crocker H. Liu, Stern School of Business, NYU

Operating Leverage:
Which type of leverage is more under managements control?
n n

operating structure: substitution among labor (variable) and machinery (fixed) financial structure: substitution among various sources of financial capital

Operating leverage exists if (EBIT - EBIT )/EBIT t t -1 = % EBIT > 1 t -1 (Sales - Sales )/Sales % Sales t t -1 t -1 The greater the degree of operating leverage, the more profits vary with a given percentage change in sales Whether an increase operating leverage is warranted depends in part on whether the prospects for future sales increases are high or unattractive.

Crocker H. Liu, Stern School of Business, NYU

Financial Leverage:
Financial leverage exists when (EPS - EPS )/EPS t t -1 t -1 = % EPS > 1 (EBIT - EBIT )/EBIT % EBIT t t -1 t -1 Indicates what happens to a firms earnings per share when financial risk is assumed

What happens if too much leverage is used

Crocker H. Liu, Stern School of Business, NYU

Combined Leverage: Operating Leverage * Financial Leverage

Combined Leverage is the total risk exposure a firm assumes can be managed by combining operating and financial leverage in different degrees.
DOL * DFL = % EBIT * % EPS = % EPS = DCL % Sales % EBIT % Sales

DOL = Degree of Operating Leverage DFL = Degree of Financial Leverage DCL = Degree of Combined Leverage Whats the proper level of overall risk a firm should accept? If the firm has a high level of fixed operating cost due to the line of business it is in, does this have any financial leverage implications?

Crocker H. Liu, Stern School of Business, NYU

Disney: Is this Entertainment?

DIS Sales % Sales 1987 2876.8 1988 3438.2 19.5% 1989 4594.3 33.6% 1990 5843.7 27.2% 1991 6182.4 5.8% 1992 7504 21.4% 1993 8529.2 13.7% 1994 10055 17.9% 1995 12112 20.5% 1996 18739 54.7% 1997 22473 19.9% 23.4% Avg Avg (xcl 1996) 19.9% DIS EBIT % EBIT 706.5 788.8 11.6% 1109.4 40.6% 1287 16.0% 1004.1 -22.0% 1287.1 28.2% 1560 21.2% 1803 15.6% 2262 25.5% 3024 33.7% 3945 30.5% 20.1% 18.6% DIS EPS 0.24 0.32 0.43 0.5 0.4 0.51 0.41 0.68 0.87 0.66 0.97 DIS % EPS DOL 33.3% 34.4% 16.3% -20.0% 27.5% -19.6% 65.9% 27.9% -24.1% 47.0% 18.9% 23.6% 0.6 1.2 0.6 -3.8 1.3 1.6 0.9 1.2 0.6 1.5 0.9 0.9 DIS DFL 2.9 0.8 1.0 0.9 1.0 -0.9 4.2 1.1 -0.7 1.5 0.9 1.3 DIS DCL 1.7 1.0 0.6 -3.5 1.3 -1.4 3.7 1.4 -0.4 2.4 0.8 1.2

*Disney acquired Capital Cities in 1996

Crocker H. Liu, Stern School of Business, NYU

Disney: Is this Entertainment?

Interpretation of Operating Leverage
If DOL = 6 then a 1% change in sales will result in a 6% fluctuation in EBIT e.g. EBIT will be six times as great

Does Disney use operating leverage e.g., does it have fixed cost which tend to magnify the fluctuations in EBIT? Given that the DOL = 1.15 for other entertainment firms, what can we say about Disneys fixed costs? Operating leverage can be negative or positive n In reality, the sales, EBIT and EPS used in t+1 are the forecasted levels.
n
Crocker H. Liu, Stern School of Business, NYU

A Note on Business Risk: What Drives it?

Components of Business Risk Sensitivity of firms product demand to general economic conditions Degree of competition If YES, then Greater Business Risk Exposure If GNP declines, does the firms sales level decline by a greater percentage? Is the firms market share small in comparison with other firms that produce and distribute the same product? Is a large proportion of the firms sales revenue derived from a single major product or product line? Does the firm utilize a high level of operating leverage resulting in a high level of fixed costs? Are the firms product markets expanding and/or changing, making income estimates and prospects highly volatile? Does the firm suffer a competitive disadvantage due to lack of size in assets, sales, or profits that translates into difficulty in tapping the capital market for funds?
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Product diversification Operating leverage Growth prospects

Size

Crocker H. Liu, Stern School of Business, NYU

Calculating Business Risk:

To calculate business risk, use a minimum of 5-10 years of EBIT.
Business Risk =

EBIT EBIT

EBIT t t=1 = = EBIT = Average EBIT N

Year 1993 1994 1995 1996 1997 1998

Disney EBIT 1560.3 1803.5 2262.1 3024 3945 3779

Disney (EBIT- )2 1365820.7 856519.4 217980.0 87034.8 1478696.5 1102535.0

EBIT

EBIT - EBIT t t=1

)2

Sum ( ) 16373.9 5108586.5 Count (N) 6 6 Mean ( ) 2729.0 851431.1 StDev( ) 922.7 CV( / ) .34 Business risk

Crocker H. Liu, Stern School of Business, NYU

Business Risk: Comparison Across the Media Entertainment (Diversified) Industry

The coefficient of variation a.k.a business risk for Time Warner (TWX) indicates that on average, $1 of EBIT can vary 31 (or 31%) in either direction. Which company has the lowest business risk in the entertainment industry? Which companies have comparable business risk?
1997 1996 1995 1994 1993 Mean() StDev() CV(/) TWX 1190 888 623 637 518 771.2 242.1 .31 NWS 1267 1252 1178 1164 1135 1199 51.49 .04 DIS 3945 3024 2262 1804 1560 2519 870.1 .35 VIAB 752.8 1363 1493 608.3 384.9 920.5 432.8 .47 KWP 192.3 191.6 162.5 127.5 151 165 24.74 .15

TWX = Time Warner NWS = News Corp DIS = Disney VIAB = Viacom KWP = King World Productions
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Crocker H. Liu, Stern School of Business, NYU

Using Business Risk Results with Leverage Ratios:

TWX 1.8 1190 661 .44 .31 NWS 2.8 1267.4 453 .64 .04 DIS 5.9 3945 669 .83 .35 VIAB 2.4 752.8 314 .58 .47 KWP NC 192.3 0 NC .15

Interest Coverage EBIT ($Mil) Interest Expense (Int) (EBIT-Int)/EBIT Business risk (CV)

(EBIT-Int)/EBIT = Percentage EBIT can decline before interest coverage is 1

Example: The business risk for Time Warner (TWX) is 31% which means that $1 of EBIT can vary either up or down by 31%. The [(EBIT-Int)/EBIT] = %EBIT can decline before interest coverage is 1 e.g. before EBIT is just enough to offset interest expense is 44%. Does this leave TWX much breathing room? Should TWX use debt financing if it has new NPV>0 projects?
Crocker H. Liu, Stern School of Business, NYU

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Sustainable Growth:
Sustainable Growth: maximum rate at which company sales can increase without depleting financial resources. Condition Fast Growth Company: Actual Growth(gA) > Sustainable Growth(gS) Where to get the cash to continue fast growth Management Strategies

Borrow cash if only a short term problem (gS ) Sell new equity Increase leverage (gS ) Reduce dividend payout ratio (gS ) Profitable pruning: sell off marginal operations and plow money back into remaining businesses (gA ) Out sourcing: do less in-house (gS ) Increase prices (gS and gA ) Merger

Moral: Growth isnt necessarily something to maximize

Crocker H. Liu, Stern School of Business, NYU

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Sustainable Growth:
Condition Management Strategies

Slow Growth Company: Continue to accumulate resources if short term problem Internal growth via R&D and organizational (gA ) Actual Growth(gA) < Sustainable Growth(gS) Ignore problem: increases p(b) of management firings Increase dividends (gS ) What to do with profits Repurchase shares (g ) S in excess of company Buy growth: diversify into other businesses (gA ) needs Financing decision is placed within the larger context of managing growth Challenge: Develop dividend, financing, and growth strategies that enable firm to expand at the desired rate without resorting to issuing new stock

Crocker H. Liu, Stern School of Business, NYU

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Using The DuPont Model to Calculate Sustainable Growth:

Crocker H. Liu, Stern School of Business, NYU

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Rapid Growth and the Virtues of Conservatism

The most powerful engine of value creation in a growing business is new investment, not interest tax shields or levered equity from debt financing.
Pecking order: The financing strategy that best facilitates growth
n n n

Maintain a conservative leverage ratio ensures continuous market access Adopt a modest dividend policy enables growth via internal financing Use cash, marketable securities, and unused borrowing capacity as temporary liquidity buffers in years when investment needs > internal sources If external financing is necessary, raise debt unless resulting leverage ratio threatens financial flexibility Sell equity or reduce growth only as a last resort

Crocker H. Liu, Stern School of Business, NYU

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Observed Capital Structure: Drug Companies

D Companies (1997) rug 1.20 1.00 .80 .60 .40 .20 .00 ABT AHP B Y GLX JNJ M K PFE P U S P SBH W A M R N G L BookValue of Debt/Eqty RE O 120% 100% 80% 60% 40% 20% 0 %
n

Firms that tend to have lower debt ratios:

n

Firms whose value depends to a greater extent on intangibles (drug, semiconductors) firms in more volatile product markets (electronics, telecom) firms with high business risk

Are capital structures identical for drug companies based on book values? Is there a relationship between debt/equity and ROE?

Crocker H. Liu, Stern School of Business, NYU

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Observed Capital Structure: Drug Companies

.070 .060 .050 80% .040 60% .030 40% .020 .010 .000 ABT AHP BMY GLX JNJ MRK PFE PNU SGP SBH WLA Market Value of Debt/Eqty ROE 20% 0% 120% 100%

Are capital structures identical for drug companies based on market values? (look closely at scale) Is there a difference between book values and market values in terms of debt/equity ratios for drug companies? Is there a relationship between the market value of debt/equity and ROE?

Crocker H. Liu, Stern School of Business, NYU

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