#9 Industry Analysis with Leverage

#9 Industry Analysis with Leverage - Risk and Financial...

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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Risk and Financial Performance It is riskier To take on High Fixed Costs Demand variation and other such factors are very powerful phenomena. To take on High Debt Interest must be paid regardless the profitability. Companies often take on the risks associated with high fixed costs (operating leverage) and debt (financial leverage) because the rewards can be considerable.
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Risk Multipliers: DOL and DFL Degree of Operating Leverage DOL = Degree of Financial Leverage DFL = % change in EBIT % change in Sales % change in net income     % change in EBIT
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Johnson and Johnson 2005 Sales = $50.5 (+ 10 % )= $55.6 +10% CGS = $ 14.0 ( +10% )= $15.4 OPEX = 23.1 (fixed) = $23.1 EBIT = $13.4 EBIT = $17.1 +27.6% (suppose sales were actually 10% higher)
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Operating Leverage Operating Leverage multiplies the short term gain or loss of contribution margin. J&J’s DOL in 2005 was 2.76x How? By having high Fixed Costs as a % of total costs (FC = $23.1 v. VC =$ 14.0)
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Degree of Financial Leverage EBIT $13.4 ( +27.6% ) $17.1 +27.6% Interest $0.1 (fixed) 0.1 Tax (24%) $3.2 Tax (24%) $4.1 Net Income $10.1 Net Income $12.9 +27.7% Continuing from DOL
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Total Leverage J&J has very little financial leverage,even though they have $2.0 billion in debt, and $54 million in interest expense. The interest expense barely affects the bottom line. DFL = 1.01x DTL = DOL x DFL 2.77 = 2.76 x 1.004 a 10 % gain in sales = a 27.7% gain in net profit ( in 2005)
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Example – Madeupcorp Revenue 1000 COGS 400 Gross Profit 600 Operating Expenses 500 Operating Profit 100 Interest Expense 40 Profit Before Taxes 60 Tax (25%) 15 Net Income 45 Actual or Current Status Revenue 1100 COGS 440 Gross Profit 660 Operating Expenses 500 Operating Profit 160 Interest Expense 40 Profit Before Taxes 120 Tax (25%) 30 Net Income 90 Effect of 10% Increase in Revenue +60% +10% +100% Degree of Operating Leverage = 60%/10% = 6x Degree of Financial Leverage = 100%/60% = 1.67x Degree of Total Leverage = 100%/10% = 10x or Degree of Total Leverage = 6x (1.67x) = 10x In other words a change in revenue will generate a ten-fold change in net income. How does that motivate the firm to act?
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Semi-Summary Risk starts at the top of the Income Statement – sales forecasting error It is multiplied by the Operating Leverage It is multiplied again by Financial Leverage This only describes short term sensitivity. Leverage can change over time. Consider the risk associated with the price of oil.  For every firm the uncertainty  of the price of oil is the same (more or less).  However, what is the risk  associated with the price of oil for the firm you are following?
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#9 Industry Analysis with Leverage - Risk and Financial...

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