Topic 7:Analysis

&Impact ofLaverage

Team BRAcct’s :Naim

AmirulAmirulAmirul

What is Leverage?O The use of borrowed money to

increase production volume, and thus sales and earnings.

O It is measured as the ratio of total debt to total assets.

Types of leveragesO Operating Leverage: Operating

leverage, just like the financial leverage, is a result of operating fixed expenses. Higher the fixed expense, higher is the operating leverage.

O Financial Leverage: Financial leverage is a leverage created with the help of debt component in the capital structure of a company.

Breakeven Point

Breakeven point (units of output)

O QB = breakeven level of Q.O F = total anticipated fixed costs.O P = sales price per unit.O V = variable cost per unit.

QB = FP - V

Breakeven Point (Cont’d)

Breakeven point (sales dollars)

O S* = breakeven level of sales.O F = total anticipated fixed costs.O S = total sales.O VC = total variable costs.

S* = F VC S

1 -

Degree of Operating Leverage

DOLs = % change in EBIT% change in sales

change in EBIT EBITchange in sales sales

=

Degree of Operating Leverage (Cont’d)

Q(P - V) Q(P - V) - F

=

DOLs = Sales - Variable Costs EBIT

Degree of Operating Leverage (Cont’d)

O If DOL = 4, then a 1% increase in sales will result in a 4% increase in operating income (EBIT).

Degree of Financial Leverage

DFL = % change in EPS% change in EBIT

change in EPS EPSchange in EBIT EBIT

=

Degree of Financial Leverage (Cont’d)

DFL = EBIT EBIT - I

Degree of Financial Leverage (Cont’d)

O If DFL = 2, then a 1% increase in operating income will result in a 2% increase in earnings per share.

Degree of Combined Leverage

DCL = DOL x DFL

=% change in EPS% change in Sales

change in EPS EPSchange in Sales Sales

=

Degree of Combined Leverage (Cont’d)

DCL = Sales - Variable Costs EBIT - I

Q(P - V) Q(P - V) - F - I

=

Degree of Combined Leverage (Cont’d)

O If DCL = 4.5, then a 1% increase in sales will result in a 4.5% increase in earnings per share.

Optimal Capital Structure

O The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

O Either to take Leverage or Cost of Capital

O By using EBIT-EPS Analysis

EBIT-EPS Analysis

EPS = (EBIT - I)(1 - t) - P S

I = interest expense, P = preferred dividends,S = number of shares of common stock outstanding.

Breakeven Point

Stock Financing Debt Financing

(Alternative 1) (Alternative 2)

(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P

S S

Thank You