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Chapter 05 The Concept of Leverage and Leverage Analysis PDF
Chapter 05 The Concept of Leverage and Leverage Analysis PDF
Chapter 05 The Concept of Leverage and Leverage Analysis PDF
And
Leverage Analysis
The Concept of Leverage
Leverage and its Meaning
• Leverage
• the use of fixed costs in an attempt to increase (or
lever up) profitability.
• Leverage in Physics
• lifting heavy weight with a small force
• Leverage in Politics
• mobilizing many people with few words
• Leverage in Finance
• changing profit significantly with slight change
in sales 2
Types of Leverage
• Operating leverage:
• the use of fixed operating costs by the firm
• present anytime a firm has fixed operating
cost-regardless of volume
• Financial leverage (Gearing):
• the use of fixed costs of financing by the firm
• acquired by choice
3
Operating Leverage
• analysis involves the short-run as all costs are
variable in the long-run
• a change in the volume of sales results in a more
than proportional change in the operating profit
(or loss) as a lever used to magnify a force applied
at one point into a larger force at some other point
• a measure of the effect of change in sales on EBIT
• a measure of operating risk and arise from fixed
operating costs
4
Effect of Operating Leverage: Example
Firm A Firm B Firm C
Sales Br. 10,000 Br. 11,000 Br. 19,500
Operating Costs:
Variable 2,000 7,000 3,000
Fixed 7,000 2,000 14,000
Operating Profit (EBIT) Br. 1,000 Br. 2,000 Br. 2,500
OL Ratios:
FC/TC .78 .22 .82
FC/Sales .70 .18 .72
5
• If sales increases by 50%, % change in EBIT = ?
Effect of Operating Leverage …
• If sales by 50%, % in EBIT would be:
Firm A Firm B Firm C
Sales Br. 15,000 Br. 16,500 Br. 29,250
Operating Costs:
Variable 3,000 10,500 4,500
Fixed 7,000 2,000 14,000
Operating Profit (EBIT) Br. 5,000 Br. 4,000 Br. 10,750
% in EBIT:
EBITt – EBITt-1
100% 400% 100% 330%
EBITt-1
6
The most sensitive firm
Break-Even Analysis
• a technique for studying the relationships among
fixed costs, variable costs, profits, and sales
volume.
• Break-even Point (BEP) Quantity :
• the point (quantity of outputs produced & sold)
where total revenues equal to total operating costs
or operating profit (EBIT) equals to zero.
EBIT = PQ – VQ – F = (P – V)Q – F
At BEP (QBE), EBIT = 0
Therefore, (P – V)QBE – F = 0
7
QBE = F/(P – V)
Example: Break-Even Point (BEP)
Quantity
• A firm producing & selling a bicycle helmet for
Br. 50 a unit. The firm‟s annual fixed operating
costs are Br. 100,000, & variable operating costs
are Br. 25 a unit regardless of the volume sold.
What is the BEP Quantity?
• QBE = F/(P – V)
• QBE = Br. 100,000 (Br. 50 – Br. 25)
• QBE = Br. 100,000 Br. 25
• QBE = 4,000units
8
Break-Even Chart
Revenue & Cost
(„000)
Total Revenue
Total Cost
300 Profit
Variable Cost
200
BEP
Loss
100 Fixed Cost
0 9
4,000 Quantity
Degree of Operating Leverage (DOL)
DOL
5
4
3
2
1
0
4,000 Quantity
-1
-2
-3
12
Financial Leverage (Gearing)
1,800,000 0.6
• EPS1,2 = = Br. 3.60
300,000 17
Indifference Points
• Indifference point between C/S (1) & P/S (3):
EBIT1,3 − I1 1−𝑡 −PD1 EBIT1,3 − I3 1−𝑡 −PD3
• =
NS1 NS3
2,750,000 0.6
• EPS1,3 = = Br. 5.50
300,000 18
EBIT-EPS Break-Even, or
Indifference, Chart
EPS (Br.)
Debt P/S
7 C/S
6
5
(2,750,000; 5.50)
4
3
(1,800,000; 3.60)
2
1
0 19
1 2 3 4
EBIT (Br. Millions)
Effect on Risk
• So far, EBIT-EPS Analysis is on return (EPS)
• An EBIT-EPS Chart does not permit a precise
analysis of risk
• Nevertheless, certain possible generalizations:
• The higher the Exp. Level of EBIT exceeding the
Indifference Point, the stronger the case for debt
financing
• Assess likelihood of future EBITs falling below the
point
• Possible fluctuations in EBIT from expected:
• EBIT > I.P & Pr.(EBITs < I.P) = Low Debt = SAFE
20
• EBIT > I.P & Pr.(EBITs < I.P) = High Debt = RISKY
EBIT-EPS Indifference Chart & EBIT
Probability Distribution
Probability of Occurrence
Debt
C/S
EPS (Br.)
SAFE
Indifference
Point
RISKY
0
0 21
EBIT (Br. Thousands)
Degree of Financial Leverage (DFL)
• A quantitative measure of the sensitivity of a
firm‟s EPS to a change in the firm‟s operating
profit (EBIT)
• The percentage change in EPS over the percentage
change in operating profit that causes the change
in EPS
% Δ in EPS
DFL@ EBIT of X Br.
% Δ in EBIT
EBIT
DFL@ EBIT of X Br.
PD
EBIT - I - [ ] 22
(1 - t)
Example: DFL
• From the previous Financing Alternatives Example;
Find the DFL@EBIT of Br. 2.7million for the:
1. Debt Financing
2. P/S Financing
EBIT
DFL@ EBIT of X Br.
PD
EBIT - I - [ ]
(1 - t)
2,700,000
1. DFL@ EBIT of Br. 2.7million 1.29
0
2,700,000 - 600,000 - [ ]
(1 - 0.4)
2,700,000
2. DFL@ EBIT of Br. 2.7million 1.51
550,000
2,700,000 - 0 - [ ] 23
(1 - 0.4)
Total Leverage
σEBIT
CVEBIT = Measure of relative
Exp(EBIT) Business Risk
28