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Financial Structure. The Impact of Leverage. Business Risk The variability in the earnings before interest and taxes Financial Risk The additional variability in the net income due to leverage. Break-Even Analysis. Break-even Point
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The Impact of Leverage • Business Risk • The variability in the earnings before interest and taxes • Financial Risk • The additional variability in the net income due to leverage Richard MacMinn
Break-Even Analysis • Break-even Point • It is that quantity at which earnings before interest and taxes, EBIT, is zero • The earning before interest and taxes is EBIT = Revenue - (Variable Cost + Fixed Cost) = R – VC – F • Letting p, q, avc, and F represent price, quantity, average variable cost and fixed cost, respectively, the EBIT can also be represented as EBIT = p q - avc q - F = (p - avc) q - F Richard MacMinn
Break-Even Analysis • The break-even point • Setting EBIT equalto zero and lettingb denote the break-even quantity, yields Richard MacMinn
Break-Even Analysis • The break-even point is random if the firm’s sales are random. Richard MacMinn
Break-Even Analysis • This slide shows how the cost and EBIT functions are affected by changes in the average variable cost. Richard MacMinn
Break-Even Analysis • The break-even point can also be affected by changing the operating leverage, i.e., fixed cost. Richard MacMinn
Business Risk • Leverage • The use of credit or borrowed funds to improve one's speculative capacity • Operating Leverage • This notion refers to the fixed cost in EBIT, independent of how it is financed. • Operating leverage is a business risk concept, i.e., as opposed to a financial risk concept. • In this case, the speculative capacity is that capacity that allows the firm to engage in risky business transactions on the chance of quick or considerable profit. Richard MacMinn
Operating Leverage • The degree of operating leverage is denoted by DOL and defined asor as Richard MacMinn
Observations The DOL is undefined at the break-even point. Operating leverage exists when DOL > 1. At sales levels above the break-even point, the DOL is a decreasing function of sales. The following figure provides a characterization of that decrease. Note that the slope of the EBIT function is p - avc while the slope of a chord from the origin to a point on the EBIT function is EBIT/q. Since the slope of the chord increases, the DOL decreases. Operating Leverage dollars R V + F EBIT c d quantity b Richard MacMinn
Operating Leverage • Observations Richard MacMinn
Financial Risk • Financial Leverage • This notion refers to the fixed costs due to debt issues • Financial leverage is a financial risk concept. • Degree of Financial Leverage (DFL) • The DFL is a measure of the responsiveness of shareholder returns to the EBIT. • The measure of shareholder returns used to determine eps is net income, NI. The NI is defined as NI = EBIT - I - T, where I represents interest on debt and T represents taxes. • NI = EBIT - I - t (EBIT - I) = (1 - t) (EBIT - I) • The DFL is defined as Richard MacMinn
Financial Leverage • Alternate Representation • Observations • The DFL = 1 for the unlevered firm • The DFL is undefined for EBIT = I • The condition EBIT < I defines a financial distress event. • The DFL is greater than one and increasing in leverage for EBIT > I. • A larger DFL implies a larger fluctuation in NI and EPS. Richard MacMinn
Degree of Financial Leverage • Note how the DFL measure changes with the interest expenses. Richard MacMinn
Leverage • For the levered firm, a one percentage change in sales implies a larger percentage change in EBIT which in turn implies an even larger percentage change in NI and EPS. • The degree of combined leverage, DCL, is a measure designed to capture these percentage changes. It is defined as Richard MacMinn
Leverage • Alternate Representation Richard MacMinn
Leverage • Alternate Representationsince NI = (1 - t) (EBIT - I) = (1 - t) ((p - avc) q - F - I) and Richard MacMinn
Leverage Observations • The DCL is undefined at the financial distress point f. • Leverage exists when DCL > 1. • At sales levels above the financial distress point, the DCL is a decreasing function of sales. • The following figure provides a characterization of that decrease. • Note that the slope of the NI function is (1 - t) (p - avc) while the slope of a chord from the origin to a point on the NI function is NI/q. Since the slope of the chord increases, the DCL decreases. dollars R V + F EBIT NI quantity f Richard MacMinn