Finansal Yönetim Operating and Financial Leverage Chapter McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Operating and Financial Leverage 55- 2 Chapter Outline What is leverage? • Break-even analysis • Operating leverage • Financial leverage • Combined leverage • Potential profits or increased risk? •5- 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 conditions5- 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- 5 Operating Leverage Extent to which fixed assets and associated • fixed costs are utilized in a business Operational costs include: • Fixed – Variable – Semivariable –5- 6 Break-Even Chart: Leveraged Firm5- 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- 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- 9 Volume-Cost-Profit Analysis: Leveraged Firm5- 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 firm5- 11 Break-Even Chart: Conservative Firm5- 12 Volume-Cost-Profit Analysis: Conservative Firm5- 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 risk5- 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- 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 volume5- 16 Operating Income or Loss5- 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- 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 = 2.75- 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- 20 Nonlinear Break-Even Analysis5- 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 leverage5- 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 $200,0005- 23 Impact of Financing Plan on Earnings per Share5- 24 Financing Plans and Earnings per Share5- 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 $32,0005- 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- 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- 28 Combined Leverage Influence on the Income Statement5- 29 Combining Operating and Financial Leverage5- 30 Operating and Financial Leverage5- 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- 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