TYPES OF LEVERAGE Operating Leverage Financial Leverage

TYPES OF LEVERAGE Operating Leverage Financial Leverage

Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance II; GEI; UCSG. 1

Questions and answers

What did we talk about last class?

Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance II; GEI; UCSG. 2

TYPES OF LEVERAGE

OPERATING LEVERAGE FINANCIAL LEVERAGE

3 Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance II; GEI; UCSG.

Why do we need to know about leverage?

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Leverage includes risk. More leverage, more risk. However, at the same time more risk implicates higher returns.

Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance II; GEI; UCSG.

LEVERAGE

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Leverage exists when the company has fixed costs and expenses. From now on we’ll call both Fixed Costs.

Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return.

More risks, we tend to expect more return (profitability). And viceversa. “No pain, no gain”.


LEVERAGE

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We have two types of costs (in terms of Cost Accounting: 1. Variable 2. Fixed How to cover the costs? - Variable costs are covered with the price - Fixed costs must be covered somehow

- HERE’S WHERE WE LEVER


TYPES OF LEVERAGE

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There are two types of leverage:

1. Operating leverage

2. Financial Leverage

FIXED COSTS


OPERATING AND FINANCIAL LEVERAGE AND THE INCOME STATEMENT

Table 12.1 General Income Statement Format and Types of Leverage

Source: Gitman, Principles of Managerial Finance


OPERATING LEVERAGE

Elaborated by and for exclusive use of Ignacio Man-Ging MBA; Finance I; GEI; UCSG. 9

OPERATING LEVERAGE It only exists when the company has fixed operating costs

This is the leverage based on operations:

We are going to cover the operating fixed costs with our operations: with our

sales.

How many units do I need to sell to cover all the costs?

Break-even point analysis: I have to find my equilibrium point of sales to keep my business.

Since this is regarding operations, the clue number is the EBIT (also called Operating Profit).


BREAK-EVEN ANALYSIS This analysis tells us what we need to cover our burden

(our operating costs).

This tells us the equilibrium point we must reach.

From here on, we know how many units we must sell.


Fixed Costs = $10.000

Fixed Costs: Variable cost per unit = $5

Price unit = $10

CONTRIBUTION MARGIN = $5

Fixed costs

$10.000

$5 $5 $5 $5 $5

Equilibrium: Fixed costs Contr. Margin

Units for equilibrium

=

Units for eq. = 2.000


OPERATING LEVERAGE Therefore our break-even point is when EBIT = 0

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EBIT = (P x Q) - FC - (VC x Q)


Mini-Exercise

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Cheryl’s Posters has fixed operating costs of $2,500, a sales price of $10 per poster, and variable costs of $5 per poster. Find the Operating Break Point (number of units I need to sell to cover my variable and fixed costs).



OPERATING LEVERAGE

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Assume that Cheryl’s Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50 (4) simultaneously implementing all three of these changes.

Exercise (Cont)


EBIT = (P x Q) - FC - (VC x Q)


(1) Operating BE point =




Exercise (Cont)


OPERATING LEVERAGE

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DEGREE OF OPERATING LEVERAGE (DOL) There are two ways to calculate it.

This number will tell me how much my profits before

interests (EBIT) will vary depending on sales changes

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DOL = Percentage change in EBIT Percentage change in Sales

DOL at base Sales level Q = Q X (P – VC) Q X (P – VC) – FC

1

2


LET’S RETURN TO THE FIRST EXERCISE

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Fixed Costs: $2.500



Applying this equation to cases 1 and 2 in Table 12.4 yields:

DOL = Percentage change in EBIT Percentage change in Sales

Case 1: DOL =

Case 2: DOL =

FIRST METHOD TO CALCULATE DOL


DOL at base Sales level Q = Q X (P – VC) Q X (P – VC) – FC

DOL at 1,000 units =

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SECOND METHOD TO CALCULATE DOL


FINANCIAL LEVERAGE


FINANCIAL LEVERAGE It only exists when the company has fixed financial costs The most common financial costs are the interests on debt and preferred stock dividends.


Chen Foods, a small Oriental food company, expects EBIT of $10,000

in the current year. It has a $20,000 bond with a 10% annual coupon

rate and an issue of 600 shares of $4 annual dividend preferred stock.

It also has 1,000 share of common stock outstanding.

The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are

$2,400 ($4/share x 600 shares).

Mini-Exercise


Mini-Exercise (Cont)

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DFL at base level EBIT = EBIT EBIT – I – [PD x 1/(1-T)]

DFL = Percentage change in EPS Percentage change in EBIT

DEGREE OF FINANCIAL LEVERAGE (DFL) There are two ways to calculate it.

This number will tell me how much my profits after interests

will vary depending on changes in my EBIT

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1

2


Applying this equation to cases 1 and 2:

DFL = Percentage change in EPS Percentage change in EBIT

Case 1: DFL =

Case 2: DFL =

FIRST METHOD TO CALCULATE DFL


DFL at base level EBIT = EBIT EBIT – I – [PD x 1/(1-T)]

DFL at $10,000 EBIT =

DFL at $10,000 EBIT =

A more direct formula for calculating DFL at a base level of EBIT is shown below.

SECOND METHOD TO CALCULATE DFL


TOTAL LEVERAGE


TOTAL LEVERAGE The total leverage is the result of both Operating and

Financial leverages It will tell us the relation between the changes in EPS with

respect a change in sales.


Mini-Exercise

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Cables Inc., a computer cable manufacturer, expects sales of

20,000 units at $5 per unit in the coming year and must meet

the following obligations: variable operating costs of $2 per

unit, fixed operating costs of $10,000, interest of $20,000, and

preferred stock dividends of $12,000. The firm is in the 40%

tax bracket and has 5,000 shares of common stock

outstanding. Table 12.7 on the following slide summarizes

these figures. Source: Gitman, Principles of Managerial Finance


DTL = Percentage change in EPS Percentage change in Sales

DEGREE OF TOTAL LEVERAGE (DTL) There are three ways to calculate it.

This number will tell me how much my EPS will vary

depending on changes in my Sales

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DTL at base sales level = Q x (P – VC) Q x (P – VC) – FC – I – [PD x 1/(1-T)]

1

2

DTL = DOL x DFL 3


Mini-Exercise (Cont)

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Applying this equation to the data:

DTL = Percentage change in EPS Percentage change in Sales

Degree of Total Leverage (DTL) =

FIRST METHOD TO CALCULATE DTL


DTL at base sales level = Q x (P – VC) Q x (P – VC) – FC – I – [PD x 1/(1-T)]

DTL at 20,000 units =

DTL at 20,000 units =

A more direct formula for calculating DTL at a base level of Sales, Q, is shown below.

SECOND METHOD TO CALCULATE DTL


DTL = DOL x DFL

The relationship between the DTL, DOL, and DFL is illustrated in the following equation:

DTL =

Applying this to our previous example we get:

THIRD METHOD TO CALCULATE DTL


For the Next Class Leverage exercises.


TYPES OF LEVERAGE Operating Leverage Financial Leverage

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