Operating and Financial Leverage

Pages: 7 (1463 words) Published: August 27, 2013
Chapter 16
Operating and Financial Leverage
After studying Chapter 16, you should be able to:
Define operating and financial leverage and identify causes of both. Calculate a firm’s operating break-even (quantity) point and break-even (sales) point . Define, calculate, and interpret a firm's degree of operating, financial, and total leverage. Understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart. Define, discuss, and quantify “total firm risk” and its two components, “business risk” and “financial risk.” Understand what is involved in determining the appropriate amount of financial leverage for a firm. Operating and Financial Leverage

Operating Leverage
Financial Leverage
Total Leverage
Cash-Flow Ability to Service Debt
Other Methods of Analysis
Combination of Methods
Operating Leverage
One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Impact of Operating Leverage on Profits

Firm F Firm V Firm 2F
Sales$10$11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit$ 1$ 2 $ 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72
Impact of Operating Leverage on Profits
Now, subject each firm to a 50% increase in sales for next year. Which firm do you think will be more “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? [ ] Firm F; [ ] Firm V; [ ] Firm 2F.

Impact of Operating Leverage on Profits
Firm F Firm V Firm 2F
Sales$15 $16.5 $29.25
Operating Costs
Fixed 7 2 14
Variable 310.5 4.5
Operating Profit$ 5 $ 4 $10.75
Percentage Change in EBIT*400% 100% 330% Impact of Operating Leverage on Profits
Firm F is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT. Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. Break-Even Analysis

When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend payments. Break-Even Chart
QUANTITY PRODUCED AND SOLD
Break-Even (Quantity) Point
How to find the quantity break-even point:
EBIT = P(Q) - V(Q) - FC
EBIT = Q(P - V) - FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units) produced and sold Break-Even (Quantity) Point
Breakeven occurs when EBIT = 0
Q (P - V) - FC= EBIT
QBE (P - V) - FC = 0
QBE (P - V) = FC
QBE = FC / (P - V)
Break-Even (Sales) Point
How to find the sales break-even point:
SBE = FC + (VCBE)
SBE = FC + (QBE )(V)
or
SBE *= FC / [1 - (VC / S) ]
Break-Even Point Example

Break-Even Point (s)
Breakeven occurs when:
QBE = FC / (P - V)
QBE = $100,000 / ($43.75 - $18.75)
QBE = 4,000 Units
SBE = (QBE )(V) + FC
SBE = (4,000 )($18.75) + $100,000
SBE = $175,000
Break-Even Chart
QUANTITY PRODUCED AND SOLD
Degree of Operating Leverage (DOL)
DOL at Q units of output
(or sales)
Computing the DOL
DOLQ units
Computing the DOL
DOLS dollars of sales
Break-Even Point Example

Computing BW’s DOL
DOL6,000 units
Interpretation of the DOL
Interpretation of the DOL
Interpretation of the DOL
DOL is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales. The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL....
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