Chapter 15 Analysis and

Impact of Leverage
 What is Leverage
Company A: sales increases 2.9
percent, but net income increases
16.9 percent.
Company B: sales decreases 3.6
percent, but net income decreases
19.4 percent.
 Two concepts that enhance
our understanding of risk...

1) Operating Leverage - affects a

firms business risk.

2) Financial Leverage - affects a

firms financial risk.
 Business Risk
The variability or uncertainty of a
firms operating income (EBIT).

Stock-
EBIT FIRM EPS holders
 Business Risk
Affected by:
Sales volume variability
Competition
Product diversification
Operating leverage
Growth prospects
Size
 Operating Leverage

The use of fixed operating costs as

opposed to variable operating
costs.
A firm with relatively high fixed
operating costs will experience
more variable operating income if
sales change.
 Financial Risk
The variability or uncertainty of
a firms earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.

Stock-
EBIT FIRM EPS holders
 Financial Leverage

The use of fixed-cost sources of

financing (debt, preferred stock)
rather than variable-cost sources
(common stock).
 Breakeven Analysis

Illustrates the effects of operating

leverage.
Useful for forecasting the
profitability of a firm, division, or
product line.
Useful for analyzing the impact of
changes in fixed costs, variable
costs, and sales price.
 Costs

Suppose the firm has both fixed

operating costs (administrative
salaries, insurance, rent, property
tax) and variable operating costs
(materials, labor, energy,
packaging, sales commissions).
 Operating Leverage

What happens if the firm

increases its fixed operating
costs and reduces (or
eliminates) its variable costs?
 Total Revenue

$ Total Cost
} EBIT
+

-
FC {
Break- Q1 Quantity
even
point
 Total Revenue

+ } EBIT

{
Total Cost
FC - = Fixed

Break-even Q1 Quantity
point
With high operating leverage,
an increase in sales
produces a relatively larger
increase in operating
income.
 Breakeven Calculations
Breakeven point (units of output)

F
QB =
P-V
QB = breakeven level of Q.
F = total anticipated fixed costs.
P = sales price per unit.
V = variable cost per unit.
 Breakeven Calculations
Breakeven point (sales dollars)
F
S* = 1-
VC
S
S* = breakeven level of sales.
F = total anticipated fixed costs.
S = total sales.
VC = total variable costs.
 Degree of Operating
Leverage (DOL)
Operating leverage: by using fixed
operating costs, a small change in
sales revenue is magnified into a
larger change in operating income.

This multiplier effect is called

the degree of operating leverage.
Degree of Operating Leverage
from Sales Level (S)

DOLs = % change in EBIT

% change in sales

change in EBIT
EBIT
=
change in sales
sales
 Degree of Operating Leverage
from Sales Level (S)
If we have the data, we can use this formula:

Sales - Variable Costs

DOLs =
EBIT

Q(P - V)
=
Q(P - V) - F
 What does this tell us?
If DOL = 2, then a 1% increase in
sales will result in a 2% increase in
operating income (EBIT).

Stock-
Sales EBIT EPS holders
 Degree of Financial
Leverage (DFL)

Financial leverage: by using fixed

cost financing, a small change in
operating income is magnified into
a larger change in earnings per
share.

This multiplier effect is called

the degree of financial leverage.
Degree of Financial Leverage

DFL = % change in EPS

% change in EBIT

change in EPS
EPS
=
change in EBIT
EBIT
Degree of Financial Leverage
If we have the data, we can use this formula:

DFL = EBIT
EBIT - I
 What does this tell us?
If DFL = 3, then a 1% increase in
operating income will result in a 3%
increase in earnings per share.

Stock-
Sales EBIT EPS holders
 Degree of Combined
Leverage (DCL)

Combined leverage: by using operating

leverage and financial leverage, a small
change in sales is magnified into a larger
change in earnings per share.

This multiplier effect is called the

degree of combined leverage.
Degree of Combined Leverage

DCL = DOL x DFL

% change in EPS
=
% change in Sales

change in EPS
EPS
=
change in Sales
Sales
Degree of Combined Leverage
If we have the data, we can use this formula:

DCL = Sales - Variable Costs

EBIT - I

Q(P - V)
=
Q(P - V) - F - I
 What does this tell us?
If DCL = 4, then a 1% increase in sales
will result in a 4% increase in earnings
per share.

Stock-
Sales EBIT EPS holders
 In-class Project:
Based on the following information on
Levered Company, answer these
questions:

1) If sales increase by 10%, what should

happen to operating income?
2) If operating income increases by 10%,
what should happen to EPS?
3) If sales increase by 10%, what should be
the effect on EPS?
 Levered Company

Sales (100,000 units) $1,400,000

Variable Costs $800,000
Fixed Costs $250,000
Interest paid $125,000
Tax rate 34%
Common shares outstanding 100,000
 Levered Company

Operating
Sales Income
EPS

Operating Financial
leverage leverage
Degree of Operating Leverage
from Sales Level (S)

Sales - Variable Costs

DOLs =
EBIT

1,400,000 - 800,000
=
350,000

= 1.714
 Levered Company

17.14%
10%

Operating
Sales Income
EPS

Operating
leverage
Degree of Financial Leverage

DFL = EBIT
EBIT - I

= 350,000
225,000

= 1.556
 Levered Company

15.56%
10%

Operating
Sales Income
EPS

Financial
leverage
Degree of Combined Leverage

DCL = Sales - Variable Costs

EBIT - I

1,400,000 - 800,000
=
225,000

= 2.667
 Levered Company

26.67%
10%

Operating
Sales Income
EPS

Operating Financial
leverage leverage
 Levered Company
10% increase in sales
Sales (110,000 units) 1,540,000
Variable Costs (880,000)
Fixed Costs (250,000)
EBIT 410,000 ( +17.14%)
Interest (125,000)
EBT 285,000
Taxes (34%) (96,900)
Net Income 188,100
EPS $1.881 ( +26.67%)