This chapter introduces the student to the concepts of operating and financial leverage and the associated business and financial risks. As a prerequisite to operating leverage, breakeven analysis is presented through graphic and algebraic methods. The limitations of breakeven analysis are also discussed.Financial leverage is presented graphically by comparing financial plans on a set of EBIT-EPS axes. The degree of operating, financial, and total leverage are presented to provide tools to measure the relative differences in risk of differing operating and financial structures within the firm. Capital structure is discussed with regard to a firm's optimal mix of debt and equity, and the EBIT-EPSand valuation model approaches to evaluate capital structure, as well as important qualitative factors, are presented.
This chapter's topics are not covered on the PMF Tutor or the PMF Problem-Solver.
A spreadsheet template is provided for the following problem:
12-2 Breakeven comparisons–Algebraic
The following Study Guideexamples are suggested for classroom presentation:
1 Degree of operating leverage
4 Breakeven analysis
ANSWERS TO REVIEW QUESTIONS
12-1 Leverage is the use of fixed-cost assets or funds to magnify the returns to owners. Leverage is closely related to the risk of being unable to meet operating and financial obligations when due. Operating leverage refers to thesensitivity of earnings before interest and taxes to changes in sales revenue. Financial leverage refers to the sensitivity of earnings available to common shareholders to changes in earnings before interest and taxes. Total leverage refers to the overall sensitivity of earnings available to common shareholders to changes in sales revenue.
12-2 The firm's operating breakeven point is the level ofsales at which all fixed and variable operating costs are covered; i.e., EBIT equals zero. An increase in fixed operating costs and variable operating costs will increase the operating breakeven point and vice versa. An increase in the selling price per unit will decrease the operating breakeven point and vice versa.
12-3 Operating leverage is the ability to use fixed operating costs tomagnify the effects of changes in sales on earnings before interest and taxes. Operating leverage results from the existence of fixed operating costs in the firm's income stream. The degree of operating leverage (DOL) is measured by dividing a percent change in EBIT by the percent change in sales. It can also be calculated for a base sales level using the following equation:
[pic]Where: Q = quantity of units
P = sales price per unit
VC = variable costs per unit
FC = fixed costs per period
12-4 Financial leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on earnings per share. Financial leverage is caused by the presence of fixed financial costs such as interest on debt and preferredstock dividends. The degree of financial leverage (DFL) may be measured by either of two equations:
Where: EPS = Earnings per share
EBIT = Earnings before interest and taxes
I = Interest on debt
PD = Preferred stock dividends
12-5 The total leverage of the firm is the combined effect of fixed costs, bothoperating and financial, and is therefore directly related to the firm's operating and financial leverage. Increases in these types of leverage will increase total risk and vice versa. Both types of leverage do complement each other in the sense that their effects are not additive but rather they are multiplicative. This means that the overall effect of the presence of these types of leverage...
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