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Allen
BFIN241
Learning Goals
1. Discuss role of breakeven analysis in leverage study, determine operating breakeven point (OBEP), and effect of changing production/sales on breakeven point. 2. Understand 3 Leverages
Degree of Operating Leverage (DOL) Degree of Financial Leverage (DFL) Degree of Combined Leverage (DCL/DTL/DGL)
3. Able to calculate DOL, DFL and DCL (DTL or DGL) as well as to implement sensitivity (indifference point of EBITs) and risk analysis. 4. Understand the implications of different leverages.
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1. Breakeven Concept
Breakeven Analysis is used by firms:
To determine the level of operations necessary to cover all operating costs, variable cost and fixed cost, and To evaluate the profitability associated with various levels of sales.
Operating leverage: how capital assets are employed Financial leverage: how the amount of debts are utilized
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$
Because the slope of Revenue > the slope of Total Cost, therefore total cost increases at slower speed when revenue increases,,
Revenue
S
At breakeven point Q*: Total revenue S* = total cost (TC) = TFC + TVC.
Breakeven point
Total Cost
At point Q: Total revenue S > total cost (TC) which is a sum of TFC and TVC. S > TC = TFC+TVC
S*
Variable Cost Fixed Cost
Q*
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Q
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Time
4
Breakeven Output
Operating Profit = (P Q) (VC Q) FC
PQ=? VC Q = ? FC = ? To determine operating breakeven point at quantity Q*:
>0 =0 <0
Allen
BFIN241
Allen
BFIN241
$ billion $20
Owner Section
Less taxes (rate 40%) Net income after tax (NIAT) $1.92
Allen
BFIN241
Income Statement
Operating Leverage
Total Leverage
Financial Leverage
Sales Revenue S = (P Q) Less: Variable operating cost (VC Q) Cost Gross margin Q (P VC) Structure Less: Fixed operating cost (FC) EBIT (operating margin) Q(P-VC) - FC Less: Interest expense EBT: (EBIT Interest cost) Less: Taxes Financial NIAT (profit margin) Structure Less: Preferred share dividends Earnings available for common shareholders (EAC) Earnings per share (EPS) Income Statement with VC and FC
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2. Operating Leverage
Operating leverage is the use of fixed operating costs (as a leverage) to magnify the effects of changes in sales (production, Q) on the firms earnings before interest and taxes (EBIT). When fixed operating costs is flat, the more you produce, the higher EBIT you obtain, assuming the price and VC/unit remain unchanged. See next slide, from EBIT0 to EBIT1 and then EBIT2 at different outputs of Q Change with quantity, Q*, produced
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The equation can be simplified (from income statement) as the ratio of the dollar value of gross margin over EBIT. DOL at base level (year) of Q is
TR TVC Sales Revenue TVC GM $ DOL = = = TR TVC FC Sales Revenue TVC TFC EBIT
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3. Financial Leverage
Financial Leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on the firms earnings per share, EPS. Two fixed financial costs can be identified in the income statement are: Interest on long-term debt, and Preferred share dividends. What about taxes?
Allen BFIN241
Sales Revenue (P * Q) Less: COGS (VC * Q) Gross margin Less: Operating cost (FC) EBIT (operating margin) Less: Interest exp. & Taxes NIAT (profit margin) Less: Preferred share divid. EAC Earnings per share (EPS)
Financial Leverage
12
= converts after-tax preferred share dividends into beforetax amount to keep consistency with the other terms.
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Operating Leverage
Operating leverage is the use of fixed operating costs (as a leverage) to magnify the effects of changes in sales (production, Q) on the firms earnings before interest and taxes (EBIT). When fixed operating costs is flat, the more you produce, the higher EBIT you obtain, assuming the price and VC/unit remain unchanged. See next slide, from EBIT0 to EBIT1 and then EBIT2 at different outputs of Q Change with quantity, Q*, produced
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Breakeven Analysis
TVC* = $2,500
11 11 11 1
TC* = $5,000
TFC = $2,500
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Sensitivity Analysis
Questions #5
EBIT2
Q*
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Q1
Q2
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Question
TR TVC Sales TVC GM $ DOL = = = TR TVC FC Sales TVC TFC EBIT
1. Should DOL be greater than 1 or equal to 1 or less than 1? 2. What does it mean when DOL = 1? 3. Can DOL equal to zero, DOL = 0? 4. What happens if DOL is zero?
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Example of DOL
XYZ has fixed operating costs of $86,000, variable operating costs of $5.48/unit, and a selling price of $8.98/unit. (use your calculator). A) Calculate the operating breakeven point in units B) Compute the DOL for the following unit sales: 25,000; 30,000; and 40,000 C) Graph the DOL figures that you computed in B) (on the y axis) against sales levels (on x axis). D) Compute the degree of operating leverage at the point of breakeven units; add this point to your graph. E) what principle is illustrated by your graph and figure? DOL Example
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20
DOL 50 40 30 25 20 15 10 5 0 15,000
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DOL curve
Breakeven point
20,000 25,000
BFIN241
$ billion $20
Owner Section
Less taxes (rate 40%) Net income after tax (NIAT) $1.92
What are DOL and DFL? If POS = 15%, what is EBIT and Net Income in next year
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Limitation s of DOL
1. Revenue and cost are linear function of volume changes. 2. Focusing on limited time period. 3. Not accounting for the timing of cash flows; 4. Limited by Opportunity cost of an investment; 5. Without considering changes in marketplace and new products
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Profit
Loss
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2. 3. 4.
5.
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3. Financial Leverage
Financial Leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on the firms earnings per share, EPS. Two fixed financial costs can be identified in the income statement are: Interest on long-term debt, and Preferred share dividends. What about taxes?
Allen BFIN241
Sales Revenue (P * Q) Less: COGS (VC * Q) Gross margin Less: Operating cost (FC) EBIT (operating margin) Less: Interest exp. & Taxes NIAT (profit margin) Less: Preferred share divid. EAC Earnings per share (EPS)
Financial Leverage
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= converts after-tax preferred share dividends into beforetax amount to keep consistency with the other terms.
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DCL implications
DCL @ base level Q = GM $ PD EBIT I 1T
Example of DCL
Firm X has sales of 100,000 units at $2/unit, VOC of $1.70/unit, and FOC of $6,000. Interest cost is $10,000/year. Firm Y has sales of 100,000 units at $2.5/unit, VOC of $1/unit. FOC of $62,500. Interest cost is $17,500/year. Assume the both firms are in the 40% tax bracket. A) Compute the DOL, DFL and DCL for Firm X. Explain the implications of your answers. B) Compute the DOL, DFL and DCL for Firm Y. Explain the implications of your answers. C) Compare the relative risks of the two firms D) Discuss the principles of leverage illustrated in your answers.
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Summary of Information
VOC X Y $1.70 $1.00 FOC $6,000 Price $2.00 Q S I Tax 100,000 $200,000 100,000 $250,000
X Sales Revenue Total variable cost (TVC) Gross Margin in dollars $ Total fixed cost (TFC) EBIT Interest payment I Earning before Taxes (EBT) Taxes amount @ 40% EAC
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$62,500 $2.50
Answer
X Y DOL 1.25 1.71 DFL 1.71 1.25 DCL 2.14 2.14
C) Firm X has less operating (business) risk but more financial risk than Firm Y. D) Two firms with differing operating and financial structures may be equally leveraged. Since total leverage is the product of operating and financial leverages, each firm may structure itself differently and still has the same amount of total risk.
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Answers A) and B)
A) Breakeven Units and Revenue
Q* = FC (P - VC) = $50,000 ($6 - $3.50) = 20,000 units S* = Breakeven quantity price/unit = 20,000 $6 = $120,000 B) EBIT and EAC Sales ($6 30,000) Less: Variable costs ($3.50 30,000) Fixed costs EBIT Less interest expense EBT Less taxes (40%) NIAT Less: Referred Dividends EAC
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$180,000 105,000 50,000 25,000 13,000 12,000 4,800 $7,200 $7,000 $200
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Answers C)
C) 30,000 units 45,000 units DOL 3.0 1.8 DFL 75.08 1.65 DCL 225.24 2.97
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Answer D)
1) % Change in EBIT = % Change in sales DOL = 50% 3 = 150% New EBIT = $25,000 + ($25,000 150%) = $62,500
2) % Change in EAC
= % Change in sales DCL = 50% 225.24 = 11,262% New EAC = $200 + ($200 11,262%) = $200 + $22,524 = $22,724 (vs. $22,700)
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+50%
NIAT
Preferred Dividends EAC
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$$7,200
$7,000 $200
+11,250%
$29,700
$7,000 $22,700
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Answer D
B) Sales ($6 45,000)
Less: Variable costs ($3.50 45,000) Fixed costs $270,000 157,500 50,000 62,500 13,000 49,500 19,800 $29,700 $7,000 $22,700
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EBIT Less interest expense EBT Less taxes (40%) NIAT Less: Referred Dividends EAC
Allen BFIN241