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Leverage
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Break Even Analysis
Relationship between Cost, Volume & Profit
At Break Even, EBIT = Zero; GP = FC
Review:
Sales/ Revenues_ COGS/ COS/ Direct Cost/ Variable Cost
= Operating Profit/ Gross Profit/ Contribution to
Overhead
_ Operating Expense/ Indirect Cost/ Overhead/ FixedCost
= Operating Income/ EBIT
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Break Even Example
Ranbaxy Laboratory sells Ax, an asthma tablet forRs20/unit to distributors; cost is Re1/unit. Fixedcosts (R& D, Marketing) of the manufacturingdivision are Rs200 million/year.
How many tablets it needs to sell per year to break even?
Per unit contribution: Selling Price Rs20
Materials (Re1)
Gross Profit Rs19
Overhead: Rs200,000,000
Break Even Point Rs200 mn / Rs19
= 10.5 mn tablets
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Funskool has licensed games from independent
designers for a 50% royalty on sale price, spends
Rs50/unit on flashy packaging, and sells the gamesfor Rs200/each. It spends Rs15,000,000 per title on
advertising. How many copies it needs to sell to
break even?
Per unit contribution: Selling Price Rs200
Cost of Sales (Rs150)
Gross Profit Rs50
Overhead: Rs15,000,000
Break Even Point Rs15mn / Rs50 = .3 million
copies
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Comparing Business Models:
Unit Sales: 5 mn 25 mn 50 mnRanbaxy Laboratory
Sales Rs100 mn Rs500 mn Rs1 billion
EBIT (Rs105 mn) Rs275 mn Rs750 mnMargin (105%) 55% 75%
Funskool
Sales Rs100 mn Rs500 mn Rs1 billionEBIT Rs10 mn Rs110 mn Rs235 mn
Margin 10% 22% 23.5%
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Comparing Breakeven PointsVariable as
% Total Cost
Fixed as %
Total Cost
Breakeven
Point
Operating
Leverage
Between Industries
LAW FIRM High Low Low Low
RanbaxyLaboratory
Low High High High
Within Industries
VINEYARD Low High High High
BOTTLER High Low Low Low
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CERTAIN RELATIONSHIPS
PBIT = Q(PV) F
PAT = (PBIT I) ( 1 T)
EPS = (PBIT
I) (1
T)
Dp
N
= [Q(P
V)
F
I] (1
T)
Dp
N
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OPERATING LEVERAGE
The sensitivity of profit before interest and taxes
(PBIT) to changes in unit sales is referred to as the
degree of operating leverage (DOL).
DOL =
PBIT/PBIT
Q / Q
=Q(P
V)
=Contribution
Q(PV) F Profit before interest and
tax
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Quantifying Operating Leverage
% Change in EBIT divided by % Change in Sales= Operating Leverage Ratio
Example: Scenario 1 Scenario 2 % changeSales Rs1,000,000 Rs1,100,000 10%
COGS (20% sales) (Rs200,000) (Rs220,000) 10%
Gross Profit Rs800,000 Rs880,000
Operating Expense (Rs500,000) (Rs500,000) Fixed
EBIT Rs300,000 Rs380,000 27%
Operating Leverage = 2.7 x
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Financial Leverage
Financial Leverage= amount of DEBT in Capital
Structure
Debt used to
Limit Shareholder Dilution
Reduce Cost of Capital Increase Shareholder returns
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EPS UNDER ALTERNATIVE FINANCING PLANS
Equity Financing Debt FinancingEBIT : 2,000,000 EBIT : 4,000,000 EBIT : 2,000,000 EBIT : 4,000,000
Interest - - 1,400,000 1,400,000
Profit before taxes 2,000,000 4,000,000 600,000 2,600,000
Taxes 1,000,000 2,000,000 300,000 1,300,000Profit after tax 1,000,000 2,000,000 300,000 1,300,000
Number of equity
shares 2,000,000 2,000,000 1,000,000 1,000,000
Earnings per share 0.50 1.00 0.30 1.30
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BREAK-EVEN EBIT LEVEL
The EBIT indifference point between two alternative
financing plans can be obtained by solving the following
equation for EBIT*
(EBIT *I1) (1t) (EBIT*I2) (1t)
=
n1 n2
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ROIROE ANALYSIS
ROE = [ROI + (ROIr) D/E] (1t)
where ROE = return on equity
ROI = return on investment
r = cost of debt
D/E = debt-equity ratio
t = tax rate
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Measuring Financial
Leverage
Financial Leverage = % Net Income% EBIT
When EBIT goes up or down, how
much does it affect Net Income?
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FINANCIAL LEVERAGE
The sensitivity of profit before tax (or profit after tax or earnings per
share) to changes in PBIT is referred to as the degree of financial
leverage.
DFL =
PBT / PBT PBIT
=
PBIT / PBIT PBIT I
=
Profit before interest and tax
Profit before tax
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Financial Leverage ExerciseExample: Scenario 1 Scenario 2 % change
EBIT Rs2,000,000 Rs2,400,000 20%
Interest Expense (Rs200,000) (Rs200,000) fixed
Pretax Income Rs1,800,000 Rs2,200,000 22%
Taxes @40% (Rs720,000) (Rs880,000)
Net Income Rs1,080,000 Rs1,320,000 22%
Financing Leverage = 1.1x
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Effects of Financial Leverage
When an investor combines equity funds
with borrowed funds to leverage an
investment, the leverage increases
Expected return to the equity investor
Risk of the investment to the equity
investor
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Measuring Total Leverage
Operating Leverage = % EBIT
% Sales
Financial Leverage = % Net Income
% EBIT
Total Leverage = % Net Income
% Sales
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Background
We know WHAT financial securities are
We know HOW to determine their cost
We know WHEN to make investments
We know HOW MUCH finance the firmneeds
We have to determine Financing Mix
How much Debt, Equity
When to choose which financing sources
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Break Even Analysis
Relationship between Cost, Volume & Profit
At Break Even, EBIT = Zero; GP = FC
Review:
Sales/ Revenues_ COGS/ COS/ Direct Cost/ Variable Cost
= Operating Profit/ Gross Profit/ Contribution to
Overhead
_ Operating Expense/ Indirect Cost/ Overhead/ FixedCost
= Operating Income/ EBIT
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Breakeven Analysis
Year 1 Year 2 Year 3 Year 4
Sales
COGS
Gross ProfitRs
high
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Breakeven Analysis
Year 1 Year 2 Year 3 Year 4
Sales
EBIT
Fixed Costs
Break Even Point
Gross Profit
hi
Rs
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Break Even Example
Ranbaxy Laboratory sells Ax, an asthma tablet forRs20/unit to distributors; cost is Re1/unit. Fixedcosts (R& D, Marketing) of the manufacturingdivision are Rs200 million/year.
How many tablets it needs to sell per year to break even?
Per unit contribution: Selling Price Rs20
Materials (Re1)
Gross Profit Rs19
Overhead: Rs200,000,000
Break Even Point Rs200 mn / Rs19
= 10.5 mn tablets
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Funskool has licensed games from independent
designers for a 50% royalty on sale price, spends
Rs50/unit on flashy packaging, and sells thegames for Rs200/each. It spends Rs15,000,000
per title on advertising. How many copies it
needs to sell to break even?
Per unit contribution: Selling Price Rs200
Cost of Sales (Rs150)
Gross Profit Rs50
Overhead: Rs15,000,000
Break Even Point Rs15mn / Rs50 = .3 million
copies
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Comparing Business Models:
Unit Sales: 5 mn 25 mn 50 mn
Ranbaxy Laboratory
Sales Rs100 mn Rs500 mn Rs1 billion
EBIT (Rs105 mn) Rs275 mn Rs750 mn
Margin (105%) 55% 75%
Funskool
Sales Rs100 mn Rs500 mn Rs1 billion
EBIT Rs10 mn Rs110 mn Rs235 mn
Margin 10% 22% 23.5%
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What does Break Even tell us?
Most costs as variable costs, typically haveLow Contribution Margin per unit (e.g., lawfirm)
Most costs as fixed costs, typically have HighContribution Margin per unit (e.g., RanbaxyLaboratory)
Compare business strategies:
Law Firm vs Ranbaxy Laboratory
Vineyard vs Bottler Quantify with Operating Leverage: change
in Sales vs change in Profits
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Comparing Breakeven PointsVariable as
% Total Cost
Fixed as %
Total Cost
Breakeven
Point
Operating
Leverage
Between Industries
LAW FIRM High Low Low Low
RanbaxyLaboratory
Low High High High
Within Industries
VINEYARD Low High High High
BOTTLER High Low Low Low
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Quantifying Operating Leverage
% Change in EBIT divided by % Change in Sales= Operating Leverage Ratio
Example: Scenario 1 Scenario 2 % change
Sales Rs1,000,000 Rs1,100,000 10%
COGS (20% sales) (Rs200,000) (Rs220,000) 10%
Gross Profit Rs800,000 Rs880,000
Operating Expense (Rs500,000) (Rs500,000) Fixed
EBIT Rs300,000 Rs380,000 27%
Operating Leverage = 2.7 x
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Operating Leverage Exercise
Example: Scenario 1 Scenario 2 % change
Sales Rs2,000,000 Rs2,200,000
COGS (10% sales) (Rs200,000) (Rs220,000)
Gross Profit Rs1,800,000 Rs1,980,000
Operating Expense (Rs1,600,000) (Rs1,600,000)
EBIT Rs200,000 Rs380,000
Operating Leverage =
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Operating Leverage Self Test
Example: Scenario 1 Scenario 2 % change
Sales Rs2,000,000 Rs2,200,000 10%
COGS (10% sales) (Rs200,000) (Rs220,000) 10%
Gross Profit Rs1,800,000 Rs1,980,000
Operating Expense (Rs1,600,000) (Rs1,600,000) Fixed
EBIT Rs200,000 Rs380,000 90%
Operating Leverage = 9.0 x
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Financial Leverage
Financial Leverage= amount of DEBT in Capital
Structure
Use Debt to:
Limit Shareholder Dilution
Reduce Cost of Capital Increase Shareholder returns
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Measuring Financial
Leverage
Financial Leverage = % Net Income% EBIT
When EBIT goes up or down, how
much does it affect Net Income?
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Financial Leverage ExerciseExample: Scenario 1 Scenario 2 % change
EBIT Rs2,000,000 Rs2,400,000 20%
Interest Expense (Rs200,000) (Rs200,000) fixed
Pretax Income Rs1,800,000 Rs2,200,000 22%
Taxes @40% (Rs720,000) (Rs880,000)
Net Income Rs1,080,000 Rs1,320,000 22%
Financing Leverage = 1.1x
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Financial Leverage Exercise
Example: Scenario 1 Scenario 2 % change
EBIT Rs2,000,000 Rs2,400,000 20%
Interest Expense (Rs1,500,000) (Rs1,500,000) fixed
Pretax Income Rs500,000 Rs900,000 80%
Taxes @40% (Rs200,000) (Rs360,000)
Net Income Rs300,000 Rs540,000 80%
Financing Leverage = 4.0x
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Financial Leverage Self Test
Example: Scenario 1 Scenario 2 % change
EBIT Rs2,000,000 Rs1,600,000 (20%)
Interest Expense (Rs1,500,000) (Rs1,500,000) fixed
Pretax Income Rs500,000 Rs100,000 (80%)
Taxes @40% (Rs200,000) (Rs40,000)
Net Income Rs300,000 Rs60,000 (80%)
Financing Leverage = 4.0x
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Effects of Financial Leverage
When an investor combines equity funds
with borrowed funds to leverage an
investment, the leverage increases
Expected return to the equity investor
Risk of the investment to the equity
investor
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Example of the effect on expected return
Consider a property that can be purchased for Rs100,000 today
that will increase in value by 2% during the next year and will
generate Rs8,000 during the year in cash flow for a total return
of 10%.
If an investor buys this building with Rs100,000 of equity funds,
the return on his equity investment will be 10%
10,000/100000 = .10
If an investor buys this building with Rs40,000 in equity and
Rs60,000 in debt at 8% interest, the return on his equity
investment is 13%
(10,000-4,800)/40000 = .13
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Example of the effect on risk Using debt funds increases the range, or volatility, of possible
outcomes, which we know as risk.
Consider two scenarios for the same property:
The Good: a 50% chance of being worth Rs112,000at the end of the year and generating Rs9000 in cashflow and
The Bad: a 50% chance of being worth Rs92,000 andgenerating Rs7,000
Our expectation (mean) is that the property will beworth Rs102,000 and generate Rs8,000 in income.
Without leverage, the range of returns to the investor is 22%(either 21% or1%).
With leverage (and the required interest payment, the range ofreturns to the investor is 55% (either 40.5% or14.5%)
Thus, leverage also increases risk.
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Why Does Leverage Work?
Leverage is favorable if the rate of return on assetsexceeds the cost of borrowing. The difference iscalled the Spread.
Favorable (positive) spread magnifies return onequity of highly leveraged investment and vise versa.
When debt service constantis less than the rate ofreturn on total assets, additional financial leverageincreases cash flow to the equity position
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Measuring Financial Leverage
Debt/equity ratioratio between borrowed
funds and equity funds
Loan/value ratioratio between borrowed
funds and market value of asset being
financed
Coverage ratioratio between NOI and debt
service.
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Measuring Financial Leverage
Greater leverage increases risk that cash flow frominvestment will be insufficient to meet debt serviceobligation (financial risk)
Debt coverage ratiodegree to which actual netoperating income can fall below expectations and still besufficient to meet debt service obligation
RATIO ANALYSIS
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RATIO ANALYSIS
Interest Coverage Ratio
Earnings before interest and taxes
Interest on debt
Cash Flow Coverage Ratio
EBIT + Depreciation + Other non-cash charges
Loan repayment instalment
(1Tax rate)Interest on debt +
RATIO ANALYSIS
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n
PATi
+ DEPi
+ INTi
+ Li
i=1DSCR =
n
INTi + LRIi + Lii=1
here DSCR = debt service coverage ratio
PATi = profit after tax for year i
DEPi = depreciation for year i
INTi = interest on long-term loan for year i
LRIi = loan repayment instalment for year iLi = lease rental for year i
n = period of the loan
RATIO ANALYSIS
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Is more leverage the better?
More leverage means higher risk Higher risk for lender means higher interest rate
Higher risk for equity investor to default.
Optimal leverage is the debt ratio that maximize theratio between return and risk.
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Determining Financing Mix: Considerations
Matching Maturity of Sources and Uses
Current Assets with Current Liabilities, etc
Minimizing Cost of Financing Maximize Stock Price
Optimal Capital Structure
Proportion of various Debt, Equity components
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Capital Structure Terminology Optimal Capital Structure
Financing Mix
Debt Capacity
Maximum Proportion of Debt to Maintain
lowest WACC
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Financing Cost & Shareholder Value
The companys Investments (Assets)generate Cash. This is ROA.
If there is only Common Stock financing,
ROA = ROE. If there is Debt financing and Kd is less
than ROA, what happens to ROE?
Reducing cost of capital increasesShareholder ROE and Shareholder Value