LEVERAGE BFINMA2: FINANCIAL

MANAGEMENT P-2
LEVERAGE
- results from the use of fixed-cost assets or funds to magnify
returns to the firm’s owners.
- The amount of leverage in the firm’s capital structure can
significantly affect its value by affecting return and risk.
TYPES OF LEVERAGE
Sales revenue
Operating Less: Cost of Goods Sold
Gross profit
Leverage Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest Total
Net profit before taxes
Leverage
Financial Less: Taxes
Net profit after taxes
Leverage Less: Preferred stock dividends
Earnings available for common stockholders

Eaarnings per share (EPS)

BREAKEVEN ANALYSIS (COST-VOLUME-PROFIT
ANALYSIS
Is used by the firm (1) to determined the operations necessary
to cover all operating cost; and (2) to evaluate the profitability
associated with various levels of sales.
ALGEBRAIC APPROACH FOR OPERATING
BREAKEVEN POINT
EBIT = (P x Q) – (VC x Q) – FC
or
EBIT = Q(P-VC) –FC
Where:
P- sales price per unit
Q- sales quantity in units
VC- variable operating cost per unit
FC- fixed cost per period
OPERATING BREAKEVEN POINT
is the level of sales necessary to cover all operating costs.
at this point, EBIT is equal to zero.
Q is the firm’s operating breakeven point.

𝐹𝐶
𝑄=
𝑃 − 𝑉𝐶
EXAMPLE
Assume that Minahal Kita Inc., a small poster retailer, has fixed
operating costs of P2,500, its sale price per unit (poster) is
P10, and its variable operating cost per unit is P5. What is the
operating breakeven point?
THE GRAPHICAL APPROACH
It is where the operating breakeven point is the point at which the total
operating cost (fixed cost plus variable operating cost) is equal to the
sales revenue.
 GRAPHICAL APPROACH
Assume that Minahal Kita
wishes to evaluate the impact
of several options (1)
increasing fixed operating
costs to P3,000, (2) increasing
the sales price per unit to
P12.5, (3) increasing the
variable operating cost per
unit to P7.50, and (4)
simultaneously implementing all
three of these changes.
SENSITIVITY OF OPERATING BREAKEVEN POINT
TO INCREASES IN KEY BREAKEVEN VARIABLES
Increase in Variable Effect on Operating
Breakeven Point
Fixed operating cost (FC) Increase
Sales price per unit (P) Decrease
Variable operating cost per unit (VC) Increase
OPERATING LEVERAGE
The potential use of fixed operating costs to magnify the
effect of changes in sales on the firm’s earnings before
interest and taxes.
OPERATING
LEVERAGE
In Minahal Kita’s example if:
Case 1: A 50% increase in
sales (from 1,000 to 1,500
units) results in 100% increase
in EBIT (P2,500 to P5,000).

Case 2: A 50% decrease in

sales (from 1,000 to 500 units)
results in a 100% decrease in
EBIT (from P2,500 to P0).
DEGREE OF OPERATING LEVERAGE (DOL)
It is the numerical measure of firm’s operating leverage.
It depends on the based on the level of sales used as a point of reference.
The closer the based sales level used to the operating breakeven point, the
greater the operating leverage.
If DOL is greater than 1, there is an operating leverage.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝐷𝑂𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
EXAMPLE
In Minahal Kita’s example if:
+100%
Case 1: A 50% increase in Case 1: = 2.0
sales (from 1,000 to 1,500 +50%
units) results in 100% increase
in EBIT (P2,500 to P5,000).

Case 2: A 50% decrease in

sales (from 1,000 to 500 units) −100%
results in a 100% decrease in Case 1: = 2.0
−50%
EBIT (from P2,500 to P0).
DOL AT THE BASE SALES LEVEL, Q

𝑄 𝑥 (𝑃−𝑉𝐶)
DOL at the base sales level Q =
𝑄 𝑥 𝑃−𝑉𝐶 −𝐹𝐶
DOL AT THE BASE PESO SALES, TR

𝑇𝑅−𝑇𝑉𝐶
DOL at the base peso sales, TR =
𝑇𝑅−𝑇𝑉𝐶−𝐹𝐶

This formula is useful for finding the DOL for multiproduct

firm.
It should be clear that because in the case of a single-
product firm, TR = PxQ and TVC=VCxQ.
FIXED COST AND OPERATING LEVERAGE
Changes in fixed operating cost affect operating leverage
significantly.
Example:
Assume that Minahal Kita exchanges a portion of its variable
operating costs for fixed operating costs by eliminating sales
commissions and increasing sales salaries. This exchange results
in a reduction in the variable operating cost per unit from P5 to
P4.50 and an increase in the fixed operating costs from
P2,500 to P3,000.
FINANCIAL LEVERAGE
Potential use of fixed financial costs (to be paid regardless
of the amount of EBIT) to magnify the changes in earnings
before interest and taxes on the firm’s earnings per share.
The two fixed financial costs are:
1. Interest on debt
2. Preferred stock dividend
EXAMPLE
NagBreak Foods, a small Asian food company, expects EBIT of
P10,000 in the current year. It has a P20,000 bond with 10%
coupon rate and an use of 600 shares of P4 preferred stock
outstanding. Assuming a tax bracket of 40% and 1,000
common stocks outstanding, what is the earnings per share?
Case 1: A 40% increase in EBIT (from P10,000 to P14,000).
Case 2: A 40% decrease in EBIT (from P10,000 to P6,000).
DEGREE OF FINANCIAL LEVERAGE (DFL)
Is the numerical measure of the firm’s financial leverage.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
𝐷𝐹𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

Whenever DFL is greater than 1, there is financial leverage.

EXAMPLE
In Minahal Kita’s example if:
+100%
Case 1: A 40% increase in EBIT Case 1: = 2.5
(from P10,000 to P14,000) +40%
results in 100% increase in
EPS.
Case 2: A 40% decrease in
EBIT (from P10,000 to P6,000)
results in 100% decrease in
EPS. −100%
Case 1: = 2.5
−40%
DFL AT BASE LEVEL EBIT
𝐸𝐵𝐼𝑇
DFL at base level EBIT = 1
𝐸𝐵𝐼𝑇−𝐼−(𝑃𝐷 𝑥 )
1−𝑇

It is possible to get a negative value for the DFL if the

EPS for the base level of EBIT is negative.
TOTAL LEVERAGE
The potential use of fixed costs, both operating and
financial, to magnify effect of changes in sales on the
firm’s earnings per share.
DEGREE OF TOTAL LEVERAGE (DTL)
Is the numerical measure of the firm’s total leverage.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆
𝐷𝑇𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

This approach is valid only when the same base level of sales
is used to calculate and compare this values. In other words, the
base level of sales must be held constant if we are to compare
the total leverage associated with different levels of fixed cost.
TOTAL LEVERAGE AT A GIVEN BASE LEVEL OF
SALES, Q
𝑄 𝑥 (𝑃−𝑉𝐶)
DTL at base sales level Q = 1
𝑄 𝑥 𝑃−𝑉𝐶 −𝐹𝐶−1−(𝑃𝐷− )
1−𝑇
RELATIONSHIP OF OPERATING, FINANCIAL &
TOTAL LEVERAGE
Total leverage reflects the combined impact of operating
and financial leverage of the firm.

𝐷𝑇𝐿 = 𝐷𝑂𝐿 𝑥 𝐷𝐹𝐿

THANK YOU!  BFINMA2: FINANCIAL
MANAGEMENT P-2
/NABERGONIA2018