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Chapter 12 Leverage and Capital Structure
Principles of Managerial Finance An-Najah National University Prepared by Lecturer: E.Shatha Qamhieh

Part one : 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. Types of leverage include: 1.Operating Leverage 2.Financial Leverage 3.Total Leverage 4/16/2012 Managerial Finance_An-Najah University 2

Types of leverage
Operating Leverage Sales revenue
Relationship between

Operating Profit EBIT

Financial Leverage Operating Profit EBIT
Relationship between

EPS

Total Leverage Sales Revenue
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Relationship between
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EPS
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General Multistep Income Statement Format and Types of Leverage

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Contribution Margin Income Statement Format
Sales

= =

Variable production expenses (such as materials, supplies, and variable overhead) Variable selling and administrative expenses Contribution margin Fixed production expenses (including most overhead) Fixed selling and administrative expenses Net operating income or loss

A contribution margin income statement is an income statement in which all variable expenses are deducted from sales to arrive at a contribution margin, from which all fixed expenses are then subtracted to arrive at the net operating income or loss for the period. 4/16/2012 Managerial Finance_An-Najah University 5

Using Contribution Margin Concept to determine Operating Breakeven Point Sales Revenue Operating Leverage Less : Variable Operating Expenses Less: Fixed Operating Expenses Earning before Interest and Taxes (P × Q) (VC × Q) FC__ EBIT

P Q FC

= = =

sales price per unit sales quantity in units fixed operating costs per period variable operating costs per unit operating profit Rewriting the algebraic calculations

VC = EBIT =

EBIT = (P x Q) - (VC x Q) - FC
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Operating Breakeven Point is: The level of sales necessary to cover all operating costs; the point at which EBIT =$0. EBIT = (P x Q) - (VC x Q) - FC To determine the operating breakeven point let EBIT =$0. Zero = QO.B.E (P - VC) - FC QO.B.E (P - VC) = FC QO.B.E = FC (P - VC) QO.B.E = Fixed Operating Cost Unit Contribution Margin

QO.B.E : is operating breakeven point in Unit Sales (QO.B.E x P ) : is operating breakeven point in dollar Sales 4/16/2012 Managerial Finance_An-Najah University 7

How changes in FC, P , FC will change Q O.B.E
QO.B.E = FC (P - VC)
Change Increase Decrease Selling price per unit (P) Variable operating cost (VC) Increase Decrease Increase Decrease Effect on Q O.B.E. Increase Decrease Decrease Increase Increase Decrease

______Variable_______ Fixed operating cost (FC)

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Conclusions of Operating Breakeven Point If Q Sales > Q O.B.E EBIT > 0 Then

Q Sales = Q O.B.E EBIT = 0

Q Sales < Q O.B.E

EBIT < 0
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Breakeven analysis can be called Cost-Volume-Profit analysis 4/16/2012

operating leverage The use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. Sales

Fixed Operating Costs

Earning Before Interest and Tax EBIT
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Measuring the Degree of Operating Leverage : Equation 1
Degree of Operating Leverage (DOL) The numerical measure of the firm’s operating leverage. For any real number a, the absolute value of a, denoted by |a| is itself if a ≥ 0, and -a if a < 0. Thus |a| is positive expect when a = 0

DOL =

Percentage change in EBIT Percentage change in sales

DOL =

%

EBIT

% sales Operating Leverage exists when : percentage change in EBIT > percentage change in sales % EBIT > % sales As long as DOL > 1...
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