DEFINITION of 'Operating Leverage' A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. 1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability. 2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage. Financial Leverage: Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share. Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.

1. Break-Even and Leverage
Operating Leverage
Financial Leverage

2. What is Leverage?

3. What is Leverage?

4. What is Leverage?

5. 2 more concepts that enhance our
understanding of risk...
1) Operating Leverage - affects a
firm’s business risk.
2) Financial Leverage - affects a
firm’s financial risk.

6. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).

7. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT

8. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT FIRM

9. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT FIRM EPS

10. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT FIRM EPS
Stock-holders

11. Business Risk
 The variability or uncertainty of a
firm’s operating income (EBIT).
EBIT FIRM EPS
Stock-holders

12. Business Risk
Affected by:
 Sales volume variability,
 Competition,
 Cost variability,
 Product diversification,
 Product demand
 Operating Leverage.

13. 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.

14. EBIT
Operating
Leverage

15. Financial Risk
 The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.

16. Financial Risk
 The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.
EBIT FIRM EPS
Stock-holders

17. Financial Risk
 The variability or uncertainty of
a firm’s earnings per share (EPS)
and the increased probability of
insolvency that arises when a
firm uses financial leverage.
EBIT FIRM EPS
Stock-holders

18. Financial Leverage
 The use of fixed-cost sources of
financing (debt, preferred stock)
rather than variable-cost sources
(common stock).

19. EPS
Financial
Leverage

20. Quantity
$
Breakeven Analysis

21. Quantity
$
Total Revenue

22. 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).

23. Quantity
{
$
Total Revenue
Total Cost
FC

24. Quantity
{
$
Total Revenue
Total Cost
FC
Break-even
point
}EBIT
Q1
+
-

25. Operating Leverage
 What happens if the firm increases
its fixed operating costs and reduces
(or eliminates) its variable costs?

26. Quantity
$
{
Total Revenue
Total Cost
FC = Fixed
Break-even
point
}
Q1
+
-
EBIT

27. With high operating leverage,
an increase in sales
produces a relatively larger
increase in operating
income.

28. Trade-off:
the firm has
a higher breakeven
point. If sales are not
high enough, the firm
will not meet its fixed
Quantity
$
{
Total Revenue
Total Cost
FC = Fixed
Break-even
point
}
Q1
+
-
EBIT
expenses!

29. Breakeven Calculations
Breakeven point (units of output)
QB =
FC
p – v

30. Breakeven Calculations
Breakeven point (units of output)
QB =
FC
p - v
QB = breakeven level of Q.
 F = total anticipated fixed costs.
 P = sales price per unit.
 V = variable cost per unit.

31. Breakeven Calculations
Breakeven point (sales dollars)
S* =
F
VC
S
1 -

32. Breakeven Calculations
Breakeven point (sales dollars)
S* =
F
VC
S
1 -
 S* = breakeven level of sales.
 F = total anticipated fixed costs.
 S = total sales.
 VC = total variable costs.

33. Analytical Income
Statement
Sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
Net Income

34. Analytical Income
Statement
Sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
Net Income
} contribution margin

35. Analytical Income
Statement
Sales
- variable costs
- fixed costs
operating income
- interest
EBT
- taxes
Net Income
EBT (1 - t) = Net Income,
so,
Net Income / (1 - t) = EBT

36. 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.

37. Degree of Operating Leverage
from Sales Level (S)
DOLs = % change in EBIT
% change in sales

38. Degree of Operating Leverage
from Sales Level (S)
DOLs = % change in EBIT
% change in sales
change in EBIT
EBIT
change in sales
sales
=

39. Degree of Operating Leverage
 If we have the data, we can use this
formula:
DOLs =
from Sales Level (S)
Sales - Variable Costs
EBIT

40. Degree of Operating Leverage
DOLs =
from Sales Level (S)
 If we have the data, we can use this
formula:
Sales - Variable Costs
EBIT
Q(p - v)
Q(p - v) - FC
=

41. What does this tell us?
 If DOL = 2, then a 1% increase
in sales will result in a 2%
increase in operating income
(EBIT).

42. 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-
EBIT holders Sales EPS

43. 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.

44. Degree of Financial Leverage
DFL = % change in EPS
% change in EBIT

45. Degree of Financial Leverage
DFL = % change in EPS
% change in EBIT
change in EPS
EPS
change in EBIT
EBIT
=

46. Degree of Financial Leverage
 If we have the data, we can use this
formula:
DFL =
EBIT
EBIT - I

47. DFL in case where there is
preferred stock
PD
T
EBIT
EBIT I
DFL

 

1

48. 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.

49. 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-
EBIT holders Sales EPS

50. 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.

51. Degree of Combined Leverage
DCL = DOL x DFL
% change in EPS
% change in Sales
=
change in EPS
EPS
change in Sales
Sales
=

52. Degree of Combined Leverage
 If we have the data, we can use this
formula:
DCL =
Sales - Variable Costs
EBIT - I

53. 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) - FC - I
=

54. DCL where there is preferred
stock
Sales VariableCost
PD
T
EBIT I
DFL

 


1

55. What does this tell us?
 If DCL = 4, then a 1% increase
in sales will result in a 4%
increase in earnings per share.

56. 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-
EBIT holders Sales EPS

57. Team 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?

58. 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

59. Leverage
Sales
DOL
EPS EBIT
DFL
DCL

60. Levered Company
Sales
DOL =
EPS EBIT
DFL
DCL

61. Levered Company
Sales
DOL = 1.714
EPS EBIT
DFL =
DCL

62. Levered Company
Sales
DOL = 1.714
EPS EBIT
DFL =
1.556
DCL

63. Levered Company
Sales
DOL = 1.714
DCL
= 2.667
EPS EBIT
DFL =
1.556

64. 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%)

65. The effect of financial leverage
 The more debt financing a firm uses in its capital structure, the more financial
leverage it employs.
Illustration:
 CFO is considering a restructuring that would involve issuing debt and using
the proceeds to buy back some of the outstanding equity.
 Firm’s market value = $ 8,000,000
 Shares outstanding = 400,000
 When all equity firm, price per share = $ 20
 Proposed debt issue would raise $ 4,000,000, interest rate = 10 %
 New debt would be used to purchase $ 4,000,000 / $ 20 = 2,00,000 shares,
leaving 2,00,000
 New Debt equity ratio = 1
 Assume that stock price will remain $20
 What is the impact of the proposed restructuring ?

66. Illustration (contd…)
Current Capital Structure: No debt
Recession Expected Expansion
EBIT $ 5,00,000 $ 1,000,000 $ 1,500,000
Interest 0 0 0
Net Income $ 5,00,000 $ 1,000,000 $ 1,500,000
ROE 6.25 % 12.50 % 18.75 %
EPS $ 1.25 $ 2.50 $ 3.75
Proposed Capital Structure: Debt = $ 4,000,000
EBIT $ 500,000 $ 1,000,000 $ 1,500,000
Interest 400,000 400,000 400,000
Net Income $ 100,000 $ 600,000 $ 1,100,000
ROE 2.50 % 15.00 % 27.50 %
EPS $ 0.50 $ 3.00 $ 5.50

67. Illustration (contd…)
• In no debt case, every
$ 400,000 increase in
EBIT increases EPS by
$ 1
• In proposed capital
structure, every $
400,000 increase in
EBIT increases EPS by
$ 2
•Breakeven point is
indifference point.
•If EBIT is above this
level, leverage is
beneficial, otherwise
not.