978-1259277160 Chapter 5 Lecture Note

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Operating and Financial Leverage

Author’s Overview

Though the student has probably covered break-even analysis in other courses, the material in

Chapter 5 offers an opportunity to more fully explore the financial effects of all forms of

leverage on the firm. The contrast between aggressive and conservative approaches should be

emphasized particularly through the useful technique of computing degrees of leverage. This

chapter also serves as a good basis for much of the later discussion in the text on the cost of

capital. The student begins to appreciate the positive benefits of debt, but also realizes that

unlimited use of debt increases the financial risk of the firm and perhaps the cost of various

other sources of financing.

Chapter Concepts

LO1. Leverage represents the use of fixed cost items to magnify the firm’s results.

LO2. Breakeven analysis allows the firm to determine the magnitude of operations necessary

to avoid loss.

LO3. Operating leverage indicates the extent to which fixed assets (plant & equipment) are

utilized by the firm.

LO4. Financial leverage shows how much debt the firm employs in its capital structure.

LO5. Combined leverage takes into account both the use of fixed assets and debt.

LO6. By increasing leverage, the firm increases its profit potential, but also its risk of failure.

Annotated Outline and Strategy

Perspective 5-1: The introduction emphasizes the airline industry as an industry that has both

high operational leverage and high financial leverage. The bankruptcy of most U.S. air carriers

should get across the point that leverage has its risk and that this chapter is very important for

anyone who intends to be a financial analyst or stock investor.

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I. Leverage in a Business: The use of fixed charge obligations with the intent of

magnifying the potential return to the firm.

A. Fixed operating costs: Those operating costs that remain relatively constant

regardless of the volume of operations such as rent, depreciation, property taxes,

and executive salaries.

B. Fixed financial costs: The interest costs arising from debt financing that must be

paid regardless of the level of sales or profits.

II. Operating Leverage: The extent to which fixed assets and associated fixed costs are

utilized in the business.

A. Break-even analysis: A numerical and graphical technique used to determine at

what point the firm will break even.

1. Break-even point: the unit sales where total revenue = total costs

2. Contribution Margin per unit is sales price (per unit) minus variable costs

per unit.

3. Formula for break-even point in units:

PPT Break-Even Chart: Leveraged Firm (Figure 5-1)

Perspective 5-2: Establish factors related to break-even analysis by illustrating the

operations of a highly leveraged firm versus a conservative firm by using Figures 5-1 and 5-2,

and Tables 5-2 and 5-3.

PPT Volume-Cost-Profit Analysis: Leveraged Firm (Table 5-2)

B. A More Conservative Approach: A firm not willing to accept the additional risk

of a higher degree of operating leverage, will only commit to lower level of fixed

costs, and thus operate further away from the breakeven point where profits will

grow at a slower rate, but if volume shrinks, there is more room to decline before

hitting the breakeven point and begin showing losses.

PPT Break-Even Chart: Conservative Firm (Figure 5-2)

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UnitperMarginon Contributi

FixedCosts

=BE

PPT Volume-Cost-Profit Analysis: Conservative Firm (Table 5-3)

C. The risk factor in using financial leverage depends on the firm’s operations

relative to its breakeven point and it operating leverage. How close to breakeven

volume is the firm’s actual operating volume? Management’s willingness to take

risk is also a function of its view of future economic conditions.

D. Cash break-even analysis

1. Deducting non-cash fixed expenses such as depreciation in the

break-even analysis enables one to determine the break-even point on a

cash basis.

2. Cash break-even point formula:

Fixed costs – (Non-cash fixed costs)

Cash BE = Contribution margin per unit

3. Although cash break-even analysis provides additional insight, the

emphasis in the chapter is on the more traditional accounting-data related

break-even analysis.

E. Degree of Operating Leverage: A reflection of the extent fixed assets and fixed

costs are utilized in the business firm. The employment of operating leverage

causes operating profit to be more sensitive to changes in sales.

1. The use of operating leverage increases the potential return but it also

increases potential losses.

2. The amount of leverage employed depends on anticipated economic

conditions, nature of the business (cyclical or noncyclical), and the risk

aversion of management.

3. The sensitivity of a firm’s operating profit to a change in sales as a result

of the employment of operating leverage is reflected in its degree of

operating leverage.

4. Degree of operating leverage (DOL) is defined as the ratio of percentage

change in operating income in response to percentage change in volume.

DOL = % change in operating income

% change in volume

5. The DOL may also be computed using the formula:

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where:

Q= quantity at which DOL is computed

P= price per unit

VC = variable cost per unit

FC = fixed costs

CM = contribution margin

EBIT = earnings before interest and taxes

6. DOL and other measures of leverage always apply to the starting point

for the range used in the computation.

PPT Operating Income or Loss (Table 5-4)

Perspective 5-3: DOL can easily be computed from the summary data on the leveraged and

conservative firm. Summary data are presented in Table 5-4 and are drawn from Tables 5-2 and

Table 5-3.

F. Limitations of Analysis: The normal assumption in doing break-even analysis is

that a linear function exists for revenue and costs as volume changes. This is

probably reasonable over a relevant range. However, for more extreme levels of

operations, some non-linearity may exist resulting in revenue weakness and cost

overruns.

PPT Nonlinear Break-Even Analysis (Figure 5-3)

III. Financial Leverage: A measure of the amount of debt used in the capital structure of

the firm. While operating leverage primarily pertains to the left-hand side of the balance

sheet (assets and associated costs), financial leverage deals with the right-hand side of

the balance sheet (liabilities and net worth).

A. Impact on Earnings:

1. Two firms may have the same operating income but greatly different net

incomes due to the magnification effect of financial leverage. The higher

the financial leverage, the greater the profits or losses at high or low

levels of operating profit, respectively.

2. Financial leverage is beneficial only if the firm can employ the borrowed

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( VC) CM

DOL = =

( VC) FC EBIT

Q P

–

– –

funds to earn a higher rate of return than the interest rate on the borrowed

amount. The extent of a firm’s use of financial leverage may be measured

by computing its degree of financial leverage (DFL).

B. The Degree of Financial Leverage: DFL is the ratio of the percentage change in

earnings per share in response to a percentage change in EBIT.

1. The DFL may also be computed utilizing the following formula:

Or, more simply

EBT

EBIT

= DFL

Where:

EBIT = Earnings before interest and taxes

EBT = Earnings before taxes

2. The DFL is associated with a specific level of EBIT and changes as EBIT

changes.

3 The purpose of employing financial leverage is to increase return to the

owners but its use also increases their risk.

Perspective 5-4: The impact of financial leverage can also be viewed in Figure 5-4.

PPT Impact of Financial Plan on Earnings per Share (Table 5-5)

PPT Financing Plans and Earnings per Share (Figure 5-4)

C. Limitations to use of Financial Leverage:

1. As the firm becomes more highly leveraged and creditors take on more

risk, they will demand higher interest rates that countermand the benefits

of financial leverage.

2. As the risk to the stockholders increases with leverage, their required

rate of return increases and stock prices may decline.

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EBITin change %

EPSin change %

= DFL

IV. Combining Operating and Financial Leverage

A. Combining operating and financial leverage provides maximum magnification of

returns-it also magnifies the risk.

B. The combined leverage effect can be illustrated through the income statement.

PPT Income Statement (Table 5-6)

Perspective 5-5: Operating income is the end result of operating leverage and the beginning

factor for financial leverage (in the form of earnings before interest and taxes). These

relationships are further enforced through Figure 5-5.

PPT Combining Operating and Financial Leverage (Figure 5-5)

PPT Operating and Financial Leverage (Table 5-7)

C. The degree of combined leverage (DCL) is a measure of the effect on net income

as a result of a change in sales. The DCL is computed similar to DOL or DFL

D. The DCL may also be computed as follows:

Perspective 5-6: Reinforce the interactive nature of the various forms of leverage. Many

firms in the Japanese economy use both high operating and financial leverages. Because of

their high combined leverage, they are hesitant to lose volume and therefore are extremely

competitive in pricing.

Finance in Action: Intel Corporation – Leverage in the Real World

The Intel Corporation example attempts to drive home the point that leverage changes from one

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salesin change %

EPSin change %

= DCL

( VC) CM

DCL = ( VC) FC EBT

Q P

Q P I

–=

– – –

financial reporting period to the next. Both operational and financial leverage are dependent on

the level of sales and the amount of debt as well as the interest expense which impacts net

income. In the Intel example, all the degrees of leverage go down as sales increase from 2013 to

2014 by 6.06% and operating income goes up 24.39%. In fact it is the degree of combined

leverage of 3.67 times that boosts operating income, net income, and earnings per share in the

second period. Students often think of the degree of leverage as a static number. This Finance in

Action Box demonstrates it is not.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 3, Glen Mount Furniture Company (financial leverage)

Case 4, Genuine Motor Products (combined leverage)

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