1. Topic 02
• Operating and Financial Leverage
5-1

2. Chapter Outline
• What is leverage?
• Break-even analysis
• Operating leverage
• Financial leverage
• Combined leverage
• Potential profits or increased risk?
5-2

3. What is Leverage?
• Use of special forces and effects to magnify
or produce more than the normal results
from a given course of action
– Can produce beneficial results in favorable
conditions
– Can produce highly negative results in
unfavorable conditions
5-3

4. Leverage in a Business
• Determining type of fixed operational costs
– Plant and equipment
• Eliminates labor in production of inventory
– Expensive labor
• Lessens opportunity for profit but reduces risk
exposure
• Determining type of fixed financial costs
– Debt financing
• Substantial profits but failure to meet contractual
obligations can result in bankruptcy
– Selling equity
• Reduces potential profits but minimize risk exposure
5-4

5. Operating Leverage
• Extent to which fixed assets and associated
fixed costs are utilized in a business
• Operational costs include:
– Fixed
– Variable
– Semivariable
5-5

6. Break-Even Chart: Leveraged Firm
5-6

7. Break-Even Analysis
• The break-even point is at 50,000 units,
where the total costs and total revenue lines
intersect
Units = 50,000 .
Total Variable Fixed Costs Total Costs Total Revenue Operating Income
Costs (TVC) (FC) (TC) (TR) (loss)
(50,000 X $0.80) (50,000 X $2)
$40,000 $60,000 $100,000 $100,000 0
5-7

8. Break-Even Analysis (cont’d)
• The break-even point can also be calculated
by:
Fixed costs = Fixed costs = FC
Contribution margin Price – Variable cost per unit P – VC
i.e. $60,000 = $60,000 = 50,000 units
$2.00 - $0.80 $1.20
5-8

9. Volume-Cost-Profit Analysis:
Leveraged Firm
5-9

10. A Conservative Approach
• Some firms choose not to operate at high
degrees of operating leverage
– More expensive variable costs may be
substituted for automated plant and equipment
– This approach may cut into potential profitability
of the firm
5-10

11. Break-Even Chart:
Conservative Firm
5-11

12. Volume-Cost-Profit Analysis:
Conservative Firm
5-12

13. The Risk Factor
• Factors influencing decision on maintaining
a conservative or leveraged stance include:
– Economic condition
– Competitive position within industry
– Future position – stability versus market
leadership
– Matching an acceptable return with a desired
level of risk
5-13

14. Cash Break-Even Analysis
• Helps in analyzing the short-term outlook of
a firm
• Noncash items are excluded:
– Depreciation
– Sales (accounts receivable rather than cash)
– Purchase of materials
– Accounts payable
5-14

15. Degree of Operating Leverage
(DOL)
• Percentage change in operating income
– Occurs as a result of a percentage change in
units sold
– Computed only over a profitable range of
operations
– Directly proportional to the firm’s break-even
point
DOL = Percent change in operating income
Percent change in unit volume
5-15

16. Operating Income or Loss
5-16

17. Computation of DOL
• Leveraged firm:
DOL = Percent change in operating income = $24,000 X 100
Percent change in unit volume $36,000
20,000 X 100
80,000
= 67% = 2.7
25%
• Conservative firm:
DOL = Percent change in operating income = $8,000 X 100
Percent change in unit volume $20,000
20,000 X 100
80,000
= 40% = 1.6
25%
5-17

18. Algebraic Formula for DOL
DOL = Q (P – VC)
Q (P – VC) – FC
Where,
• Q = Quantity at which DOL is computed
• P = Price per unit
• VC = Variable costs per unit
• FC = Fixed costs
• For the leveraged firm, assume Q = 80,000, with P = $2, VC = $0.80,
and FC = $60,000:
DOL = 80,000 ($2.00 - $0.80) ;
80,000 ($2.00 - $0.80) - $60,000
= 80,000 ($1.20) = $96,000 ;
80,000 ($1.20) - $60,000 $96,000 - $60,000
i.e. DOL = 2.7
5-18

19. Limitations of Analysis
• Weakening of price in an attempt to capture
an increasing market
• Cost overruns when moving beyond an
optimum-size operation
• Relationships are not fixed
5-19

20. Nonlinear Break-Even Analysis
5-20

21. Financial Leverage
• Reflects the amount of debt used in the
capital structure of the firm
– Determines how the operation is to be financed
– Determines the performance between two firms
having equal operating capabilities
BALANCE SHEET
Assets Liabilities and Net Worth
Operating leverage Financial leverage
5-21

22. Impact on Earnings
• Examine two financial plans for a firm, where
$200,000 is required to carry the assets
Total Assets = $200,000
Plan A (leveraged) Plan B (conservative)
Debt (8% interest) $150,000 ($12,000 interest) $50,000 ($4,000 interest)
Common stock 50,000 (8000 shares at $6.25) 150,000 (24,000 shares at $6.25)
Total financing $200,000 $200,000
5-22

23. Impact of Financing Plan on
Earnings per Share
5-23

24. Financing Plans and Earnings
per Share
5-24

25. Degree of Financial Leverage
DFL = Percent change in EPS
Percent change in EBIT
• For the purpose of computation, it can be restated as:
DFL = EBIT .
EBIT – I
• Plan A (Leveraged):
DFL = EBIT = $36,000 = $36,000 = 1.5
EBIT – I $36,000 - $12,000 $24,000
• Plan B (Conservative):
DFL = EBIT = $36,000 = $36,000 = 1.1
EBIT – I $36,000 - $4,000 $32,000
5-25

26. Limitations to Use
of Financial Leverage
• Beyond a point, debt financing is detrimental
to the firm
– Lenders will perceive a greater financial risk
– Common stockholders may drive down the price
• Recommended for firms that are:
– In an industry that is generally stable
– In a positive stage of growth
– Operating in favorable economic conditions
5-26

27. Combining Operating
and Financial Leverage
• Combined leverage: when both leverages
allow a firm to maximize returns
– Operating leverage:
• Affects the asset structure of the firm
• Determines the return from operations
– Financial leverage:
• Affects the debt-equity mix
• Determines how the benefits received will be
allocated
5-27

28. Combined Leverage Influence
on the Income Statement
5-28

29. Combining Operating
and Financial Leverage
5-29

30. Operating and Financial
Leverage
5-30

31. Degree of Combined Leverage
• Uses the entire income statement
• Shows the impact of a change in sales or
volume on bottom-line earnings per share
DCL = Percentage change in EPS ;
Percentage change in sales (or volume)
• Using data from Table 5-7:
Percent change in EPS = $1.50 X 100
$1.50 = 100% = 4
Percent change in sales $40,000 X 100 25%
$160,000
5-31

32. Degree of Combined Leverage
(cont’d)
DCL = Q (P – VC) ,
Q (P – VC) – FC – I
From Table 5-7,
• Q (Quantity) = 80,000; P (Price per unit) = $2.00; VC (Variable costs
per unit) = $0.80; FC (Fixed costs) = $60,000; and I (Interest) =
$12,000.
DCL = 80,000 ($2.00 - $0.80) =
80,000 ($2.00 - $0.80) - $60,000 - $12,000
= 80,000 ($1.20) =
80,000 ($1.20) - $72,000
DCL = $96,000 = $96,000 = 4
$96,000 - $72,000 $24,000
5-32

33. END
5-33

34. Q&A
5-34

35. Thank You.
5-35