05 analysis and impact of leverage.pdf
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Analysis and Impact of Leverage
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What is Leverage?
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Two Types of LeverageOperating Leverage - affects a firms business risk.
Financial Leverage - affects a firms financial risk.
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Two Types of RiskBusiness Risk
relative dispersion (variability) in the firm's expected
earnings before interest and taxes
Financial Risk
direct result of the firm's financing decision. this risk applies to
(1) the additional variabilityin earnings available to the
firm's common shareholders; and
(2) the additional chance of insolvency borne by the
common shareholder caused by the use of financial
leverage,
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Business Risk Coefficient of Variation of Expected EBIT
The relative dispersion in the firm's EBIT stream, measured here by itsexpected coefficient of variation
Example:
L4D has an expected value of EBIT equal to 690,000 w/ an associated
standard deviation of 25,000
COHs expected EBIT is 912,000 w/ an associated standard deviation of
61,0000
Operating Leverage
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Business RiskAffected by:
Sales volume variability Competition
Product diversification
Operating leverage
Growth prospects Size
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Financial Risk Financing Leverage
means financing a portion of the firm's assets with securities bearing afixed (limited) rate of return in hopes of increasing the ultimate return
to the common stockholders.
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Break-Even Analysis Break-even quantity output
results in an EBIT level equal to ___?___.
Use of the break-even model
(1) to determine the quantity of output that must be sold to cover all
operating costs, as distinct from financial costs, and (2) to calculate the EBIT that will be achieved at various output levels.
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Break-Even Analysis Essential Elements of the Break-Even Analysis:
Fixed Cost
Variable Cost
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Fixed Cost Total fixed costs are independent of the quantity of product
produced and equal some constant dollar amount.
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Units Produced and Sold
Cost
(Php)
Fixed-Cost Behavior over Relevant Range of Output
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Variable Cost Total variable costs are computed by taking the variable cost per unit
and multiplying it by the quantity produced and sold
The break-even model assumes proportionality between total
variable costs and sales. Thus, if sales rise by 10 percent, it is
assumed that variable costs will rise by 10 percent.
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Cost(Php)
Variable-Cost Behavior over Relevant Range of Output
Units Produced and Sold
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QuestionWhat happens if the firm increases its fixed
operating costs and reduces (or eliminates) itsvariable costs?
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Total Revenue and Volume of OutputTotal Revenue
Total sales dollars
Volume of Output
The firm's level of operation expressed either in sales dollars oras units of output.
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Finding the Break-Even Point Finding the break-even point in terms of units of production can be
accomplished in several ways.
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SCENARIO DBZ Company manufactures several different products, and has
observed over a lengthy period that its product mix is ratherconstant.
This allows management to conduct its financial planning by use of a
"normal" sales price per unit and "normal" variable cost per unit.(both are calculated from the constant product mix this is likeassuming that the product mix is one big product)
The selling price is $10 and the variable cost is $6.
Total fixed costs for the firm are $100,000 per year.
What is the break-even point in units produced and sold for thecompany during the coming year?
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Trial and Error Analysis
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Contribution-Margin Analysis difference between the unit selling price and unit variable costs
"contribution" in the present context means contribution to the
coverage of fixed operating costs.
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Algebraic AnalysisBreakeven point (units of output)
QB = breakeven level of Q (# of units sold)
F = total anticipated fixed costs.P = sales price per unit.
V = variable cost per unit.
QB =F
P - V
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Breakeven Calculations (Sales dollars)Breakeven point (sales dollars)
S* = breakeven level of sales.F = total anticipated fixed costs.S = total sales.VC = total variable costs.
S* =F
VC
S1 -
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Breakeven Calculations (Sales dollars)Analytical Statement
Sales $300,000
Total variable cost 180,000
Revenue before fixed cost 120,000
Total fixed cost 100,000
EBIT 20,000
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Graphic Representation
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Degree of Operating LeverageOperating leverage: by using fixed operating costs, a
small change in sales revenue is magnified into alarger change in operating income.
This multiplier effect is called the degree of
operating leverage.
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Degree of Operating LeverageAssuming DBZ is currently operating at an annual
sales level of $300,000 (base sales level at t = 0)
Question: How will DBZ's EBIT level respond to a
positive 20 percent change in sales at
t +1 ?
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DOLs =% change in EBIT
% change in sales
change in EBIT
EBIT
change in salessales
=
Degree of Operating Leverage from Sales Level (S)
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Degree of Operating Leverage from Sales Level (S)If we have the data, we can use this formula:
S
VC _SVCF
=
DOLs =Sales - Variable Costs
EBIT
Q(P - V) _
Q(P - V) - F
=
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Degree of Financial Leverage Financial leverage: by using fixed cost financing, a small change in
operating income is magnified into a larger change in earnings pershare.
This multiplier effect is called the degree of financial leverage.
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Degree of Financial LeverageLet us assume that the DBZ have calculated that $200,000 is
needed to purchase the necessary assets to conduct thebusiness.
Three possible financing plans have been identified for raising
the $200,000; Plan A: no financial risk is assumed: The entire $200,000 is raised by
selling 2,000 common shares, each with a $100 par value.
Plan B: a moderate amount of financial risk is assumed: 25 percent ofthe assets are financed with a debt issue that carries an 8 percent annual
interest rate. Plan C: would use the most financial leverage: 40 percent of the assels
would be financed with a debt issue costing 8 percent
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DFL = % change in EPS% change in EBIT
change in EPSEPS
change in EBIT
EBIT
Degree of Financial Leverage
=
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Degree of Financial Leverage If we have the data, we can use this formula:
DFL =EBIT
EBIT - I
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Degree of Combined LeverageCombined leverage: by using operating leverage and
financial leverage, a small change in sales is magnified intoa larger change in earnings per share.
This multiplier effect is called the degree of combinedleverage.
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DCL = DOL x DFL
Degree of Combined Leverage
=% change in EPS
% change in Sales
change in EPS
EPSchange in Sales
Sales
=
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DCL =Sales - Variable Costs
EBIT - I
Degree of Combined Leverage If we have the data, we can use this formula:
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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) - F - I
=