Chapter 12

Leverage and
Capital
Structure

Copyright 2012 Pearson Prentice Hall.

All rights reserved.

Objectives

Discuss leverage, capital structure, breakeven

analysis, the operating breakeven point, and the effect
of changing costs on the breakeven point.

Understand operating, financial, and total leverage

and the relationships among them.

Describe the types of capital and the external

assessment of capital structure.

2012 Pearson Prentice Hall. All rights reserved.

12-2

Leverage
Leverage refers to the effects that fixed costs have on the
returns that shareholders earn; higher leverage generally
results in higher, but more volatile returns.
Fixed costs are costs that do not rise and fall with changes in a
firms sales volume. Firms have to pay these fixed costs whether
business conditions are good or bad.
Generally, leverage magnifies both returns and risks.

Capital structure is the mix of long-term debt and equity

maintained by the firm.

2012 Pearson Prentice Hall. All rights reserved.

12-3

Leverage (cont.)
Operating leverage is concerned with the relationship
between the firms sales revenue and its earnings before
interest and taxes (EBIT) or operating profits.
Financial leverage is concerned with the relationship
between the firms EBIT and its common stock earnings
per share (EPS)
Total leverage is the combined effect of operating and
financial leverage. It is concerned with the relationship
between the firms sales revenue and EPS.

2012 Pearson Prentice Hall. All rights reserved.

12-4

General Income Statement Format and

Types of Leverage

2012 Pearson Prentice Hall. All rights reserved.

12-5

Impact of Operating Leverage on Profits

Before:
Firm A

Firm B

Firm C

$ 10,000

$ 11,000

$ 19,500

Fixed (FC)

7000

2000

14000

Variable (VC)

2000

7000

3000

$ 1,000

$ 2,000

$ 2,500

Sales
Operating Costs:

Operating Profit (EBIT)

After: (50% Increase)

Firm A

Firm B

Firm C

$ 15,000

$ 16,500

$ 29,250

Fixed (FC)

7000

2000

14000

Variable (VC)

3000

10500

4500

$ 5,000

$ 4,000

$ 10,750

Sales
Operating Costs:

Operating Profit (EBIT)

2012 Pearson Prentice Hall. All rights reserved.

12-7

Leverage: Breakeven Analysis

Breakeven analysis is used to indicate the level of operations
necessary to cover all costs and to evaluate the profitability
associated with various levels of sales; also called cost-volumeprofit analysis.
The operating breakeven point is the level of sales necessary to
cover all operating costs; the point at which EBIT = $0.
The first step in finding the operating breakeven point is to divide the cost of
goods sold and operating expenses into fixed or variable operating costs.
Fixed costs are costs that the firm must pay in a given period regardless of
the sales volume achieved during that period.
Variable costs vary directly with sales volume.

2012 Pearson Prentice Hall. All rights reserved.

12-8

Leverage: Breakeven Analysis

Using an algebraic calculation as a formula for earnings
before interest and taxes yields:
EBIT = (P Q) (VC Q) FC
Simplifying yields:
EBIT = Q (P VC) FC
Setting EBIT equal to $0 and solving for Q (the firms
breakeven point) yields:

2012 Pearson Prentice Hall. All rights reserved.

12-9

Leverage: Breakeven Analysis

(cont.)
Assume that Cheryls Posters, a small poster retailer,
has fixed operating costs of $2,500. Its sale price is
$10 per poster, and its variable operating cost is $5
per poster. What is the firms breakeven point?

2012 Pearson Prentice Hall. All rights reserved.

12-10

Leverage: Breakeven Analysis

(cont.)
Assume that Cheryls Posters wishes to evaluate the impact of several
options:
(1) increasing fixed operating costs to $3,000,
(2) increasing the sale price per unit to $12.50,
(3) increasing the variable operating cost per unit to
$7.50, and
(4) simultaneously implementing all three of these
changes.

2012 Pearson Prentice Hall. All rights reserved.

12-11

1. Operating breakeven point = $3,000/($10 $5) = 600 units

2. Operating breakeven point = $2,500/($12.50 $5) = 333 units
3. Operating breakeven point = $2,500/($10 $7.50) = 1,000 units
4. Operating breakeven point = $3,000/($12.50 $7.50) = 600
units

2012 Pearson Prentice Hall. All rights reserved.

12-12

Break Even of Dollar Sales

The
general rule of operating profit is
By multiplying and dividing with variable cost,

Eventually I t can be

2012 Pearson Prentice Hall. All rights reserved.

12-13

Leverage: Operating Leverage

(cont.)
The degree of operating leverage (DOL) is the
numerical measure of the firms operating leverage.

As long as DOL is greater than 1, there is operating

leverage.

2012 Pearson Prentice Hall. All rights reserved.

12-14

The
calculations are based historical data which cant help us
analyze the future operating profits generation. A more
accurately used formulas used for Degree of Leverage are
below,
For quantity,
For Dollars of sales,

2012 Pearson Prentice Hall. All rights reserved.

12-15

Leverage: Operating Leverage

(cont.)
A more direct formula for calculating the degree of
operating leverage at a base sales level, Q, is the following:

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

into the above equation yields the following result:

2012 Pearson Prentice Hall. All rights reserved.

12-16

Leverage: Operating Leverage

(cont.)
Assume that Cheryls Posters exchanges a portion of its
variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales salaries.
This exchange results in a reduction in the variable
operating cost per unit from $5 to $4.50 and an increase in
the fixed operating costs from $2,500 to $3,000.

2012 Pearson Prentice Hall. All rights reserved.

12-17

End to DOL

2012 Pearson Prentice Hall. All rights reserved.

12-18