A Group Presentation

Introduction
Leverage results from the use of fixed-cost assets or funds to magnify returns to the firms owners. Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return. The amount of leverage in the firms capital structurethe mix of debt and equitycan significantly affect its value by affecting risk and return.

Definition and Types of Leverage

Leverage may be defined as the use of fixed cost items to magnify returns at high levels of operation. There are two types of Leverage:

General Income Statement Format and Types of Leverage

Break Even Point (BEP)

Break-even analysis is used to determine the level of operations at which a firm neither makes a profit nor losses money. At this level, the firms operate at a ZERO point of level (Sales = FC + VC) or Break-even point. Break-even analysis makes use of fixed cost, Variable costs and Sales and may be used Graphically or Mathematically.

Break Even Point Analysis: Mathematical Approach

Using the following variables, the operating portion of a firms income statement may be recast as follows:
S = sales price per unit Q = sales quantity in units FC = fixed operating costs per period VC = variable operating costs per unit

Letting EBIT = 0 and solving for Q, we get:

EBIT = (S x Q) - FC - (VC x Q)

Break Even Point Analysis: Mathematical Approach (cont.)

Break Even Point Analysis: Mathematical Approach (cont.)

Operating Leverage, Costs, and Breakeven Analysis

Break Even Point Analysis: Mathematical Approach (cont.)

Example: Cheryls Posters has fixed operating costs of $2,500, a sales price of $10 per poster, and variable costs of $5 per poster. Find the OBP.
Q (BEP in units) = $2,500 = 500 posters $10 - $5

This implies that if Cheryls sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).

Break Even Point Analysis: Mathematical Approach (cont.)

We can check to verify that this is the case by substituting as follows: EBIT = (P x Q) - FC - (VC x Q) EBIT = ($10 x 500) - $2,500 - ($5 x 500) EBIT = $5,000 - $2,500 - $2,500 = $0

Break Even Point Analysis: Graphical Approach

Break Even Analysis

Operating Leverage: Measuring the Degree of Operating Leverage

Degree of operating leverage (DOL) may be define as the percentage change in operating income that occurs as a result of a percentage changes in units sold. Formula: DOL = Contribution Margin = CM Earning Before Interest & Tax EBIT Effect of Operating Leverage: DOL = % changes in EBIT % changes in Sales

Degree of Operating Leverage: Example

Problem: A company is perfectly selling 5000 units of a product @ $20 per unit. If variable cost is $6 per unit & fixed operational cost are $ 80000. Find DOL Solution: Sales = 20*5000 = 100000 VC = 30000 CM = 70000 (-) FC = 80000 EBIT = 10000 Therefore, DOL = 70000/10000 = 7 Times. (ans.)

Financial Leverage: Measuring the Degree of Financial Leverage

Degree of Financial Leverage (DFL) may be defined as the percentage change in earnings per share (EPS) that occurs as a result of a percentage change in earings before interest & taxes(EBIT). Formula: DFL = Earning Before Interest & Taxes = EBIT Earning Before Taxes EBT Effect of Financial Leverage: DFL = % changes in EPS % changes in EBIT

Degree of Financial Leverage: Example

Problem: A companys EBIT= $10000 & it has 5% bonds for $40000 & preference shares =20000. Calculate Degree of Financial Leverage.
Solution: EBIT = 10000 (-) Interest = 2000 EBT = 8000 Therefore, DFL = 10000/8000 = 1.25 Times (ans.)

Degree of Total/Combined Leverage (DCL/DTL)

Degree of Total/Combined Leverage (DCL/DTL) uses the entire income statement and shows the impact of a change in sales or volume on bottom-line EPS. Degree of operating leverage (DOL) and Degree of Financial Leverage (DFL) are, in effect, being combined that is, DCL = DOL x DFL. Effect of Combined Leverage: DCL = % changes in EPS % changes in sale

Degree of Total/Combined Leverage (DCL/DTL): Example

Problem: A company having a total capital of $1000000 including 60% bonds with 10% equity. The expected sales of firm = 20000 units $20 per unit, VC = $10 per period, fixed operational cost = $50000, calcualte DOL, DFL & DCL. Solution: Sales = 400000 (-) VC = 200000 Contribution = 200000 (-) FC = 50000 EBIT = 150000

Degree of Total/Combined Leverage (DCL/DTL): Example (cont.) EBIT = 150000 (-) Interest = 60000 EBT = 90000 Therefore, DOL = 200000/150000 = 1.33 times DFL = 150000/90000 = 1.67 times DCL = DOL*DFL = 1.33 * 1.67 = 2.22 times (ans.)