vv-7 - s THE TWO-EDGED SWORD Mind Map Mind s s s In the...

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Unformatted text preview: s THE TWO-EDGED SWORD Mind Map Mind s s s In the physical sciences, “leverage” refers to the In ability to magnify effort. In finance, we borrow this term and use it in a similar way to describe the impact of fixed costs the Leverage refers to the magnification of operating Leverage or financial results from the use of fixed costs or Two flavors: operating and financial leverage Mind Map Mind s Learning objective: – Develop an understanding of what creates Develop operating and financial leverage operating – Describe the impact of leverage on operating Describe profits and net income/EPS profits – Distinguish between operating leverage and Distinguish financial leverage financial – Measure the amount of leverage inherent in a Measure firm’s operations firm’s – Predict the impact of changes in sales or Predict operating profits Mind Map Mind s Key words/concepts: – Financial leverage, operating leverage – DOL, DFL, DCL – Fixed cost, break-even, contribution margin Fixed Question Question (Answer in a few minutes) s Why does the typical physician work so Why many hours? many Two sources of risk Two 1) Business (or Operating) Risk 1) Business variability associated with operating income. operating 2) Financial Risk - risk of distress or 2) Financial bankruptcy due to the use of fixed cost financing. cost Business Risk Business s The variability or uncertainty of a The firm’s operating income (EBIT). firm’s Business Risk Business Affected by: s Sales volume variability, s Competition, s Cost variability, s Product diversification, s Product demand s Operating Leverage. Operating Operating Leverage Operating s The use of fixed operating costs as The fixed opposed to variable operating costs. costs. s A firm with relatively high fixed firm operating costs will experience more variable operating income if more sales change. sales Operating Leverage Operating s The use of fixed operating costs as The fixed opposed to variable operating costs. costs. s A firm with relatively high fixed firm operating costs will experience more variable operating income if more sales change. sales Costs Costs s Suppose the firm has both fixed Suppose operating costs (administrative operating salaries, insurance, rent, property tax) and variable operating costs variable (materials, labor, energy, packaging, sales commissions). sales Breakeven Analysis $ Quantity Total Revenue $ Quantity Quantity Total Revenue $ Total Cost FC { Quantity Quantity Total Revenue $ + }EBIT Total Cost FC { Breakeven point Q1 Quantity Quantity Operating Leverage Operating s What happens if the firm increases What its fixed operating costs and reduces (or eliminates) its variable costs? (or Total Revenue $ + FC { } Q1 EBIT Total Cost = Fixed Quantity Quantity Breakeven point Total Revenue Trade-off: Trade-off: $ FC { Breakeven point the firm has the a higher breakeven higher EBIT point. If sales are not + enough, the firm high will not meet its fixed will Total Cost expenses! = Fixed } Q1 Quantity Quantity With high operating leverage, operating an increase in sales sales produces a relatively larger increase in operating income. income Degree of Operating Leverage (DOL) Leverage s Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a sales larger change in operating income. operating s This “multiplier effect” is called This the degree of operating leverage. degree Degree of Operating Leverage from Degree Sales Level (S) Sales DOLs = % change in EBIT change % change in sales change in EBIT EBIT EBIT change in sales sales sales = Degree of Operating Leverage from Sales Level s If we have the data, we can use this If formula: formula: DOLs = Sales - Variable Costs EBIT EBIT = Q(P - V) Q(P - V) - F Q(P What does this tell us? What s If DOL = 2, If DOL then a 1% increase then 1% in sales will result in a 2% 2% increase in operating income (EBIT). (EBIT). Answer to Opening Question Answer Many small physician practices have a Many DOL in the 5-7 range (WOW!) DOL s A efficient Doc can see about 20 patients efficient in an 8-schedule-hour day in s What happens if she decides to “cutback” from 20 to 19 patients per day? s 5% decrease in revenue x DOL of 5 = 5% 25% decline in operating profit s Financial Risk Financial s The variability or uncertainty of The a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. financial Financial Leverage Financial s The use of fixed-cost sources of The fixed-cost financing (debt, preferred stock) rather than variable-cost sources variable-cost (common stock). (common Financial Leverage Example Example s s s s s s Suppose you buy a house for $100,000 in cash Suppose (equity). If the value increases to $110,000, what is your ROE? what ROE (all equity financing) = 10% What if you bought the house with $10k in What equity and a $90k loan? equity ROE (leveraged) = 100% ($10k/$10k) Leverage magnifies returns!! What if the value falls by $10,000? Degree of Financial Leverage (DFL) Leverage s Financial leverage: by using fixed by cost financing (i.e., debt), a small change in operating income is operating magnified into a larger change in earnings per share. earnings s This “multiplier effect” is called This the degree of financial leverage. degree Degree of Financial Leverage Degree DFL = % change in EPS change % change in EBIT change in EPS EPS EPS change in EBIT EBIT EBIT = Degree of Financial Leverage s If we have the data, we can use this If formula: formula: EBIT DFL = EBIT - I EBIT What does this tell us? What s If DFL = 3, If DFL then a 1% increase then 1% in operating income will result in a 3% increase in earnings per 3% share. share. Thought for the Day/Job Search Minute Combo Minute s s s Preparing for a meaningful and rewarding career is a Preparing high priority for right-thinking people high However, Elder Wirthlin teaches: While we are taught to However, develop our talents and provide for our families, nevertheless we must be careful not to let the pursuit of our career path divert us from the gospel path. our Nothing this world has to offer can surpass the joy of Nothing living the gospel! No worldly wealth or possession, no degree of fame or recognition can supplant the satisfaction of feeling the warmth and peace of the Spirit of the Lord in our hearts and in our homes. “Sweet is the peace the gospel brings.” peace Degree of Combined Leverage (DCL) Leverage s Combined leverage: by using operating leverage and financial leverage, a small leverage financial small change in sales is magnified into a larger sales change in earnings per share. earnings s This “multiplier effect” is called the degree This of combined leverage. of Degree of Combined Leverage Degree DCL = DOL x DFL % change in EPS change = % change in Sales change in EPS EPS EPS change in Sales Sales Sales = Degree of Combined Leverage s If we have the data, we can use this If formula: formula: DCL = Sales - Variable Costs EBIT - I EBIT Q(P - V) Q(P - V) - F - I Q(P = What does this tell us? What s If DCL = 4, If DCL then a 1% increase then 1% in sales will result in a 4% 4% increase in earnings per share. increase Team Project: Team s Based on the following information on Based Levered Company (next slide), answer these questions: these 1) If sales increase by 10%, what should 1) sales happen to operating income? operating 2) If operating income increases by 10%, 2) operating what should happen to NI/EPS? NI/ 3) If sales increase by 10%, what should be 3) sales the effect on NI/EPS? NI/ Levered Company Levered Sales (100,000 units) $1,400,000 Variable Costs $800,000 $800,000 Fixed Costs $250,000 $250,000 Interest paid $125,000 $125,000 Tax rate 34% 34% Common shares outstanding 100,000 100,000 HINT: start by making an income stmt!! Levered Company Levered Sales (100,000 units) Variable Costs Variable Fixed Costs Fixed EBIT EBIT Interest Interest EBT EBT Taxes (34%) Taxes Net Income Net EPS EPS 1,400,000 (800,000) (250,000) 350,000 (125,000) 225,000 (76,500) 148,500 $1.485 Degree of Leverage Calculations s DOL = (Sales – VC)/EBIT DOL – =(1,400-800)/350 = 1.714 s DFL = EBIT/ (EBIT –I) – =350/(350 – 125) = 1.556 s DCL = DOL x DFL – =1.71 x 1.56 = 2.667 =1.71 Leverage Leverage Sales DCL DOL EPS DFL EBIT Levered Company Levered Sales DCL DOL = EPS DFL EBIT Levered Company Levered Sales DCL DCL DOL = 1.714 EPS DFL = DFL EBIT Levered Company Levered Sales DCL DOL = 1.714 EPS DFL = DFL 1.556 1.556 EBIT Levered Company Levered Sales DCL = 2.667 DOL = 1.714 EPS DFL = DFL 1.556 1.556 EBIT Levered Company 10% increase in sales Sales (110,000 units) Sales Variable Costs Variable Fixed Costs Fixed EBIT EBIT Interest Interest EBT EBT Taxes (34%) Taxes Net Income Net EPS EPS 1,540,000 (880,000) (250,000) (250,000) 410,000 ( +17.14%) +17.14%) (125,000) (125,000) 285,000 (96,900) (96,900) 188,100 $1.881 ( +26.67%) +26.67%) The Infamous Test 2 The s s s Same Format: 25 questions; no time limit, any calculator, dictionary Will be harder than Test 1 (as previously indicated!) Topics: – – – – – Stocks – 4-6 questions Debt – 4-6 questions Leverage – 2-4 questions Capital budgeting – 10-13 questions (Wow!) Personal finance – 1-2 questions ...
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