Lecture 12A – Financial and Operating Leverage

In this note we are going to look at the concept of leverage, and how it might affect
decisions. In the next lectures a great deal is going to be said about this topic in terms of
finance theory. We want to motivate that discussion by looking at the topic more
intuitively first.

Financial Leverage:

Consider that you want to start a firm. You know what product you are going to produce.
You need to decide how to finance this new company. The company will need $10,000
of total capital. There are two alternative financing mechanisms. You finance with equity
or debt. In that case of equity, you will sell common stock shares at $10 per share. If
you borrow, the interest rate will be 5%. Let us further assume that when you start
operations you will produce net operating income of $1,000 per year. There are two
alternative capital structures. In the first case, you could go with 100% equity. In the
second case you could go with 50% equity and 50% debt. Assuming a non-tax world,
which capital structure should be chosen?

Case 1. Un-leveraged

Total Capital = $10,000

Total Equity = $10,000
Total Number of shares sold = 10,000 / 10 = 1,000 shares

Case 2. Leveraged

Total Capital = $10,000

Total Equity = $5,000
Total Debt = $5,000
Number of shares of common stock = 5,000 / 10 = 500
Interest payment per year = .05(5,000) = $250

Which capital structure will produce more cash flows for the stock holders? Since it is
the same company, they both start from the same net operating income.

Structure U L

NOI 1,000 1,000

Interest 0 (250)
NI 1,000 750
EPS = NI/# of shares 1.00 1.50

Under this example it looks as if the leveraged structure delivers more per share of profits
to share holders than the un-leveraged structure.

Remember that the operations are the same in both cases. The only thing that is different
is the way the firm is financed. The ability to increase the returns of share holders by
using debt is what is normally called leverage. So we can define financial leverage as the
increase in EPS resulting from the introduction of fixed interest debt in the capital
structure. This debt acts like a lever on share holder returns.

The temptation is then to declare the leveraged structure as the optimal structure.

If we go back to the example we remember that we have not produced anything yet. We
are still at the point of deciding how to start. So the figure of NOI = 1,000 is just an
estimate. We could be wrong. In fact let us assume that the chances of producing 1,000
or 250 are 50% each. Let us see if that changes things a little bit.

U L

NOI 1,000 250 1,000 250

Interest 0 0 (250) (250)
NI 1,000 250 750 0
EPS 1.00 .25 1.50 0
Expected EPS .625 .75
Risk .14 .56

It is no longer very clear which structure is better.

L still has the higher expected EPS, but it also has a higher level of risk. We are
measuring risk here by variance of EPS.

If we remember that the business is the same. The business risk is the same in both cases.
This is shown by the fluctuation in NOI is the same in both cases. For the firm with no
debt, all the risk must be from fluctuations in business income. In the case of leverage,
the interest payments cause the fluctuations in EPS to be bigger. The only difference
between the two is the method of financing. Since the business risk must be the same in
both cases, the increase in risk in L must be the result of the use of debt. This is
financing risk. We can define financing risk as the increase in the total risk of the firm
resulting from the use of debt in the capital structure. In our example it can be measured
as .56 - .14 = .42.

Let us look at some more possible NOI.

U:

NOI 1,500 1,000 500 250 0 -250

INT 0 0 0 0 0 0
NI 1,500 1,000 500 250 0 -250
EPS 1.50 1.00 .50 .25 0 -.25

L:

NOI 1,500 1,000 500 250 0 -250

INT (250) (250) (250) (250) (250) (250)
NI 1,250 750 250 0 -250 -500
EPS 2.50 1.50 .50 0 -.50 -1.0

We see two things from the information above. First, leverage tends to magnify gains
and losses to EPS. Second, at NOI greater than 500, leverage is good, and at NOI less
than 500, leverage is bad.

Operating Leverage

When we talk about financial leverage we are talking essentially about how the firm’s
income is distributed between equity holders and debt holders. Let us look more closely
at how the net income is generated.

Define Revenues as P.Q

Costs are usually categorized as fixed or variable cost. Thus total costs are the sum of
variable costs and fixed costs. So if V is variable per unit, and F is total fixed costs, the
total costs = VQ + F.

Profit is defined as the difference between total revenue and total cost.

Π = TR − TC = PQ − F −VQ

Often we are interested in calculating the break even point in operations.

The break even point is the quantity at which profits equal zero, the point at which
TR = TC.

Break even Quantity.

F
QB =
P −V
The term P-V is usually called ACM or the average contribution margin.

Consider the case where P = 85, F = 300,000, and V = 10.

 300 ,000
QB = = 4,000 units
85 −10

We could also calculate break even in sales as:

F F
SB = =
 V   TVC 
1 −  1 − 
 P   TR 

Using the example above, sales break even was 4,000 x 85 = $340,000.

300 ,000
SB = = $340 ,000
 10 
1 − 
 85 

From the equation for breakeven, we see that the break even quantity can be reduced by:
• Reducing the fixed cost
• Reducing the average variable cost
• Increasing the price.

Consider a firm which wants to build a plant and there are two competing designs, A and
B. They have different costs structures.

TCA = 600,000 + 21,000Q

TCB = 780,000 + 18,000Q

At what product level will the firm be indifferent between the two designs?
The revenues will not be different since the firm will sell at the same price and the same
quantity. What must be equal is the total cost.

600,000 + 21,000Q = 780,000 + 18,000Q

Q = 60

At any output higher than 60, design B is more efficient. At output below 60, plant A is
more efficient.

The firm might want to determine how much its operating profits would be affected by
shifts in demand given the two types of technology.

Operating leverage is the measure of how fixed costs affect profits.

It is measured as

Q( P −V )
OL Q =
Q ( P −V ) − F
So taking the two competing plants at Q = 60, and a price of $33,000 we can determine
their degrees of operating leverage as:

60 (33 ,000 − 21,000 )

OL A = = 6.0
60 (33 ,000 − 21,000 ) − 600 ,000

60 (33 ,000 −18 ,000 )

OL B = = 7.5
60 (33 ,000 −18 ,000 ) − 780 ,000

Take the case of plant B, this means that starting from output of 60, a 1% increase in
production and sales will result in a 7.5% increase in profit. If you take plant A, a 1%
increase in quantity sold will increase profits by 6%.

The degree of operating leverage measures the sensitivity of profits to the level of
production and sales. This means that it is the same thing as the sales elasticity of profits:

∆Π/ Π ∆Π Q
ΕΠ = = .
∆Q / Q ∆Q Π

From Plant B, let production increase from 60 to 61 units

Π60 = 60 ($ 33 ,000 − $18 ,000 ) − $780 ,000 = $120 ,000

Π61 = 61($ 33 ,000 − $18 ,000 ) − $780 ,000 = $135 ,000

At 60 units of output the elasticity is

15 60
ΕΠ = . = 7.5
1 120

Let us collect our thoughts so far.

• The degree of operating leverage shows the change in operating profits for a
given change in sales.
• For plant B the degree of operating leverage is 7.5. This means that a one
percent increases in sales will increase net operating profits by 7.5%. A one
percent decrease in sales will cause a 7.5% decrease in profits.
• The higher the level of fixed costs, the higher the degree of operating leverage.
• Fixed costs of operations affect operating profits through leverage, which is
business risk
• Fixed financing costs affect Net Income through leverage, which is financial risk.
• The level of total leverage is the combination of operating and financial leverage.
 • If a firm has high fixed operating cost and then finances its operations using high
levels of debt, it is increasing its total leverage, and its total risk.

Problems:

1. The Congress Company has identified two methods for producing cards. One method
involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per
deck of cards. The other method would use a less expensive machine with fixed costs of
$5,000, but would require variable costs of $1.50 per deck of cards. If the selling price
per deck of cards will be the same under each method, at what level of output will the
two methods produce the same net operating income?

2. Hensley Corporation uses breakeven analysis to study the effects of expansion

projects. Currently, the firm’s plastic bag business segment has fixed costs of $120,000,
while its unit price per carton is $1.20 and its variable cost is $0.60. The firm is
considering a new bag machine and an automatic carton folder as modifications to its
existing production lines. With the expansion, fixed costs would rise to $240,000, but
variable cost would drop to $0.41 per unit. If this happens, Hensley could lower its
selling price to $1.05 per carton, and this would likely double its market share. What is
the change in the breakeven volume with this proposed project?

3. US Auto Company would like to offer rebates to its customers in order to increase
sales. If it lowers prices sales will increase. This will depend on the price elasticity of
demand. Assume that the price elasticity of demand is 1.5. This firm is considering a
$400 rebate on its cars. Also assume the following information on prices and costs
before the rebates:
Average price per car $9,000 per car
Expected sales volume at $9,000) per car 1,000,000 cars
Average total costs per car $8,200 per car
Total variable cost $6,400,000,000

• Calculate the present total fixed cots, average variable costs and average fixed
costs.
• What is the present breakeven point?
• What is the change in revenue resulting from the $400 price reduction?
• What is the effect on the cost per car after the change? In other words what is the
average cost per car after the change?
• Should the change be made?