Cf Final Leverage

7/31/2019 Cf Final Leverage

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Learning GoalsDiscuss leverage, capital structure, breakeven

analysis, the operating breakeven point, and the

effect of changing costs on it.

Understand operating, financial, and total

leverage and the relationship among them.

Copyright 2009 Pearson Prentice Hall. All rightsreserved. 12-2


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LeverageLeverage results from the use of fixed-cost assets or fundsto magnify returns to the firms owners.

Generally, increases in leverage result in increases in riskand return , whereas decreases in leverage result indecreases in risk and return.

The amount of leverage in the firms capital structure

the mix of debt and equity can significantly affect its value by affecting risk and return.



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Leverage (cont.)


Table 12.1 General Income Statement Format and Typesof Leverage


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Breakeven AnalysisBreakeven (cost-volume-profit) analysis is used to:

determine the level of operations necessary to cover alloperating costs, andevaluate the profitability associated with various levels of sales.

The firms operating breakeven point (OBP) is thelevel of sales necessary to cover all operating expenses. At the OBP, operating profit (EBIT) is equal to zero.



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Breakeven Analysis (cont.)To calculate the OBP, cost of goods sold and operatingexpenses must be categorized as fixed or variable.

Variable costs vary directly with the level of sales and are afunction of volume, not time.

Examples would include direct labor and shipping.

Fixed costs are a function of time and do not vary with sales volume.

Examples would include rent and fixed overhead.



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Breakeven Analysis:

Algebraic Approach (cont.)


Table 12.2 Operating Leverage, Costs, and Breakeven Analysis


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Breakeven Analysis:

Algebraic Approach (cont.)

This implies that if Cheryls sells exactly 500 posters,its revenues will just equal its costs (EBIT = $0).


Q = $2,500 = 500 posters$10 - $5

Example: Cheryls Posters has fixed operating costsof $2,500, a sales price of $10 perposter, and variable costs of $5 per poster.Find the OBP.


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Breakeven Analysis: Changing Costs and the

Operating Breakeven Point


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.


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Breakeven Analysis: Changing Costs and the

Operating Breakeven Point


(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units


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Operating Leverage (cont.)


Table 12.4 The EBIT for Various Sales Levels


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Operating Leverage: Measuring the Degree of

Operating LeverageThe degree of operating leverage (DOL)measures the sensitivity of changes in EBIT tochanges in Sales. A companys DOL can be calculated in twodifferent ways: One calculation will give you apoint estimate , the other will yield an intervalestimate of DOL.Only companies that use fixed costsin the production process will experienceoperating leverage.



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Operating Leverage: Measuring the Degree of

Operating Leverage (cont) A more direct formula for calculating DOL at a basesales level, Q, is shown below.


DOL at base Sales level Q = Q X (P VC)Q X (P VC) FC

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

the following result:

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.01,000 X ($10 - $5) - $2,500


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Operating Leverage: Fixed Costs

and Operating Leverage


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 variable costs per

unit from $5.00 to $4.50 and an increase in fixed operating

costs from $2,500 to $3,000

DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.21,000 X ($10 - $4.50) - $2,500


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Operating Leverage: Fixed Costs

and Operating Leverage (cont.)


Table 12.5 Operating Leverage and Increased Fixed Costs


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Financial LeverageFinancial leverage results from the presence of fixed financial costs in the firms income stream.

Financial leverage can therefore be defined as thepotential use of fixed financial costs to magnify the effects of changes in EBIT on the firms EPS.

The two fixed financial costs most commonly found on the firms income statement are (1)interest on debt and (2) preferred stockdividends .



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Financial Leverage (cont.)


Chen Foods, a small Oriental food company, expects EBIT of

$10,000 in the current year. It has a $20,000 bond with a 10%

annual coupon rate and an issue of 600 shares of $4 annualdividend preferred stock. It also has 1,000 share of common

stock outstanding.

The annual interest on the bond issue is $2,000 (10% x$20,000). The annual dividends on the preferred stock are

$2,400 ($4/share x 600 shares).


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Financial Leverage (cont.)


Table 12.6 The EPS for Various EBIT Levelsa


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Financial Leverage: Measuring the Degree of

Financial LeverageThe degree of financial leverage (DFL)measures the sensitivity of changes in EPS tochanges in EBIT.Like the DOL, DFL can be calculated in twodifferent ways: One calculation will give you apoint estimate , the other will yield an intervalestimate of DFL.Only companies that use debt or other forms of fixed cost financing (like preferred stock) willexperience financial leverage.



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Financial Leverage: Measuring the Degree of

Financial Leverage (cont) A more direct formula for calculating DFL at a baselevel of EBIT is shown below.


DFL at base level EBIT = EBITEBIT I [PD x 1/(1-T)]

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and thetax rate, T = 40% yields the following result:

DFL at $10,000 EBIT = $10,000$10,000 $2.000 [$2,400 x 1/(1-.4)]

DFL at $10,000 EBIT = 2.5


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Total LeverageTotal leverage results from the combined effect of using fixed costs, both operating and financial, tomagnify the effect of changes in sales on the firms

earnings per share.Total leverage can therefore be viewed as the totalimpact of the fixed costs in the firms operating andfinancial structure.



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Total Leverage (cont.)


Cables Inc., a computer cable manufacturer, expects sales of

20,000 units at $5 per unit in the coming year and must meet

the following obligations: variable operating costs of $2 perunit, fixed operating costs of $10,000, interest of $20,000, and

preferred stock dividends of $12,000. The firm is in the 40%

tax bracket and has 5,000 shares of common stockoutstanding. Table 12.7 on the following slide summarizes

these figures.


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Total Leverage: Measuring the

Degree of Total Leverage (cont.) A more direct formula for calculating DTL at a baselevel of Sales, Q, is shown below.


DTL at base sales level = Q x (P VC)Q x (P VC) FC I [PD x 1/(1-T)]

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000,PD = $12,000, and the tax rate, T = 40% yields the following result:

DTL at 20,000 units = $60,000/$10,000 = 6.0

DTL at 20,000 units = 20,000 X ($5 $2)20,000 X ($5 $2) $10,000 $20,000 [$12,000 x 1/(1-.4)]


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Total Leverage: The Relationship of Operating, Financial

and Total Leverage


DTL = DOL x DFL

The relationship between the DTL, DOL, and DFL is illustratedin the following equation:

DTL = 1.2 X 5.0 = 6.0

Applying this to our previous example we get:


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Total Leverage (cont.)


Table 12.7 The Total Leverage Effect


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17 End of Chapter

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Cf Final Leverage