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Lecture Fundamentals of financial management (13/e) - Chapter 16: Operating and financial leverage

After Studying Chapter 16, you should be able to: Define operating and financial leverage and identify causes of both; calculate a firm’s operating break-even (quantity) point and break-even (sales) point; define, calculate, and interpret a firm's degree of operating, financial, and total leverage; understand EBIT-EPS break-even, or indifference, analysis, and construct and interpret an EBIT-EPS chart;. | Chapter 16 Operating and Financial Leverage © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Operating and Financial Leverage Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods Operating Leverage One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Operating Leverage -- The use of fixed operating costs by the firm. Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales $10 $11 $19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit $ 1 $ 2 $ 2.5 FC/total costs .78 .22 .82 FC/sales .70 .18 .72 (in thousands) Impact of Operating Leverage on Profits Now, subject each firm to a 50% increase in sales for next year. Which firm do you think will be more “sensitive” to the change in sales (i.e., show the largest percentage change in operating profit, EBIT)? [ ] Firm F; [ ] Firm V; [ ] Firm 2F. Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales $15 $16.5 $29.25 Operating Costs Fixed 7 2 14 Variable 3 10.5 4.5 Operating Profit $ 5 $ 4 $10.75 Percentage Change in EBIT* 400% 100% 330% (in thousands) * (EBITt - EBIT t-1) / EBIT t-1 Impact of Operating Leverage on Profits Firm F is the most “sensitive” firm -- for it, a 50% increase in sales leads to a 400% increase in EBIT. Our example reveals that it is a mistake to assume that the firm with the largest absolute or relative amount of fixed costs automatically shows the most dramatic effects of operating leverage. Later, we will come up with an easy way to spot the firm that is most sensitive to the presence of operating leverage. Break-Even Analysis When studying operating leverage, “profits” refers to operating profits before taxes (i.e., EBIT) and excludes debt interest and dividend | Chapter 16 Operating and Financial Leverage © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Operating and Financial Leverage Operating Leverage Financial Leverage Total Leverage Cash-Flow Ability to Service Debt Other Methods of Analysis Combination of Methods Operating Leverage One potential “effect” caused by the presence of operating leverage is that a change in the volume of sales results in a “more than proportional” change in operating profit (or loss). Operating Leverage -- The use of fixed operating costs by the firm. Impact of Operating Leverage on Profits Firm F Firm V Firm 2F Sales $10 $11 $19.5 Operating Costs Fixed 7 2 14 Variable 2 7 3 Operating Profit $ 1 $ 2 $ 2.5 FC/total costs .78 .22 .82 FC/sales .70 .18 .72 (in thousands) Impact of Operating Leverage on Profits Now, subject each firm to a 50% increase in sales for next year. Which firm do you think will be more “sensitive”