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Topics: Break-Even Analysis, Operating and Financial Leverage, and Optimal Capital Structure

This document provides information and examples about various finance topics: 1. It defines break-even analysis and provides examples of calculating break-even point in sales and units. It also shows how to calculate break-even for multiple products. 2. It defines operating leverage as the extent a company uses fixed costs, and provides an example of calculating operating leverage factor and how profits are affected by a change in sales. 3. It defines financial leverage as using debt to increase production and earnings, and provides an example of calculating degree of financial leverage and how earnings per share is affected by a change in EBIT. 4. It discusses optimal capital structure as the debt-equity mix that maximizes firm value or minimizes

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magoimoi
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2K views

Topics: Break-Even Analysis, Operating and Financial Leverage, and Optimal Capital Structure

This document provides information and examples about various finance topics: 1. It defines break-even analysis and provides examples of calculating break-even point in sales and units. It also shows how to calculate break-even for multiple products. 2. It defines operating leverage as the extent a company uses fixed costs, and provides an example of calculating operating leverage factor and how profits are affected by a change in sales. 3. It defines financial leverage as using debt to increase production and earnings, and provides an example of calculating degree of financial leverage and how earnings per share is affected by a change in EBIT. 4. It discusses optimal capital structure as the debt-equity mix that maximizes firm value or minimizes

Uploaded by

magoimoi
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Lara Rica J.

Ras
BE323/ 8:00-9:00 AM
Prof. Eduardo de Gracia
Source: MAS Reviewer of Roque, Investopedia.com
Topics: Break-Even Analysis, Operating and Financial Leverage, and Optimal Capital Structure
Contribution Margin Income Statement
Sales (units x selling price)
Less: Variable Cost (units x variable cost per unit)
Contribution Margin
Less: Total Fixed Cost
Income before Tax

XX
(XX)
XX
(XX)
XX

Break Even Analysis


Break Even Point is where Sales volume level (in pesos or in units) where total revenues equals total
costs, that is, there is neither profit nor loss.
1. BEP in Pesos
BEPp =
Total Fixed Cost .
Contribution Margin Ratio*
*CMR =
2. BEP in Units
BEPU =

Contribution Margin
Sales
Total Fixed Cost .
Contribution Margin per Unit*

*CM/u =

Contribution Margin
Total Units
Illustration 1: Basic Illustration Corp. produces and sells a single product. Its Contribution Income
Statement is as follows:
Sales (10,000 units @ P10)
P100,000
Variable Cost (10,000 @ P6)
(60,000)
Contribution Margin
40,000
Fixed Cost
(30,000)
Profit before Tax
P 10,000
Questions:
1. What is the Contribution Margin Ratio?
2. What is the BEP in Sales?
3. What is the Contribution Margin per Unit?
4. What is the BEP in Units?
Answers:
1. CMR =
2. BEP in Sales =

Contribution Margin = 40,000


Sales
100,000
Total Fixed Cost

= 40%

30,000 = P 75,000

Contribution Margin Ratio

40%

3. CM/u = Contribution Margin = 40,000 = P 4


Total Units
10,000
4. BEPU =
Total Fixed Cost
= 30,000 = 7,500 units
Contribution Margin per Unit
4
How to solve BEP with multiple products?
Illustration 2: A company sells Products A, B, and C. Data about the products is as follows:
A
B
C
Total
Selling Price
P100
P120
P50
VC per unit
60 90 40
CM per unit
P40
P30
P10
Sales in Units
1,000 2,000
5,000
8,000
Total Fixed Cost
P101,680
Questions:
1. What is the Weighted Average Contribution Margin Ratio?
2. What is the BEP in Sales?
3. What is the Contribution Margin per Unit?
4. What is the BEP in Units?
1. CMR =

Contribution Margin = 150,000


Sales
590,000

2. BEP in Sales = Total Fixed Cost


=
Contribution Margin Ratio

= 25.42%

101,680 = P 400,000
25.42%

Breakdown of BEP in Sales


Total
Product A
B
C
Sales Mix Ratio
(16.95%)
(40.68%) (43.37)
BES
P 400,000P 67,800 P 162,720P 169,480
3. CM/u = Contribution Margin = 150,000 = P 18.75
Total Units
8,000
4. BEPU =
Total Fixed Cost
= 101,680 = 5,422.93 units
Contribution Margin per Unit
P18.75
Breakdown of BEP in Units
Total
Product A
B
Sales Mix Ratio
(12.5%)
(25%)
BES
5,422.93 677.87 1,355.733,389.33

(62.5%)

Operating Leverage is the extent to which a company uses fixed costs in its cost structure.
Operating Leverage Factor
It is used to measure the extent of change in profit before tax resulting from the change in Sales.
OLF =Contribution Margin or % in Profit before Tax
Profit before Tax
% in Sales
Illustration 3: Basic Illustration Corp. produces and sells a single product. Its Contribution Income
Statement is as follows:
Sales (10,000 units @ P10)
P100,000
Variable Cost (10,000 @ P6)
(60,000)
Contribution Margin
40,000
Fixed Cost
(30,000)
Profit before Tax
P 10,000
Question:
1. What is the OLF?
2. If the companys Sales would increase by 10%, what is the effect in profit before tax?
Answers:
1. OLF = Contribution Margin = 40,000 = 4
Profit before Tax
10,000
2.

4 x 10% =

40%

Proof:
Sales (10,000 units @ P10)
Variable Cost (10,000 @ P6)
Contribution Margin
Fixed Cost
Profit before Tax

Proposed
P100,000
110,000 Increase by 10%
(60,000) (66,000)
40,000
44,000
(30,000) (30,000)
P 10,000 P 14,000
Increase by 40%

Financial leverage
It is the use of borrowed money to increase production volume, and thus sales and earnings. It is
measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the
financial leverage.
Degree of Financial Leverage
This measures the percentage change in earnings per share over the percentage change in EBIT.
DFL =
EBIT
or % in EPS
EBIT-interest
% in EBIT

Illustration 4: With New Co's current production, its sales are P 7 million annually. The company's
variable costs of sales are 40% of sales, and its fixed costs are P2.4 million. The company's annual
interest expense amounts to P100,000 annually. (Assume there are 60,000 shares)
Sales
7,000,000
Variable cost (2,800,000)
CM
4,200,000
FC
(2,400,000)
EBIT
1,800,000
Questions:
1. What is DFL?
2. If we increase New Co's EBIT by 20%, how much will the company's EPS increase?
Answers:
1. DFL =

EBIT =
1,800,000
= 1.058
EBIT-interest
1800,000 100,000
2. 1.058 x 20% = 21.2%
Proof:
Proposed
EBIT
1,800,000
2,160,000 increase by 20%
Interest
(100,000)(100,000)
Net income bef. Tax 1,700,000 2,060,000
Tax 30%
(510,000)(618,000)
Net Income
1,190,000
1,442,000
Divided by:
60,000 60,000
EPS
19.83
24.03 increase by 21.20%

The Optimal Capital Structure


It is a mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital
Capital structure is most often referred to as a firm's debt-to-equity ratio, which provides insight into
how risky a company is for potential investors.
Illustration 5: Unlevered: Assets = Equity = 100

GOOD:

SALES 100.00
COSTS 70.00
EBIT
30.00
INT
0.00
EBT
30.00
TAX
12.00
NI
18.00
ROE
18%

Illustration 6: Levered: A = 100: D = E = 50


GOOD:
SALES 100.00
COSTS 70.00
EBIT
30.00
INT
5.00
EBT
25.00
TAX
10.00
NI
15.00
ROE
30%

BAD:

BAD:

SALES 82.50
COSTS 80.00
EBIT
2.50
INT
0.00
EBT
2.50
TAX
1.00
NI
1.50
ROE
1.5%

SALES 82.50
COSTS 80.00
EBIT
2.50
INT
5.00
EBT
(2.50)
TAX
(1.00)
NI
(1.50)
ROE
(3%)

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