Chapter 16

Operating
Operating and
and
Financial
Financial Leverage
Leverage

16.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Operating Leverage

Operating Leverage – The use of

fixed operating costs by the firm.
16.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 • One potential “effect” caused by
the presence of operating leverage
is that a change in the volume of
sales results in a “more than
proportional” change in operating
profit (or loss).

16.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Impact of Operating
Leverage on Profits
Firm
(in thousands) F Firm V Firm 2F
Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
(O.P)EBIT $ 1 $ 2 $ 2.5
FC/total costs 0.78 0.22 0.82
FC/sales 0.70 0.18 0.72
16.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Impact of Operating
Leverage on Profits
• Now, subject each firm to a 50%
increase in sales for next year.
• Which firm do you think will be more
“sensitive” to the change in sales (i.e.,
show the largest percentage change
in operating profit, EBIT)?
[ ] Firm F; [ ] Firm V; [ ] Firm 2F.

16.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Impact of Operating
Leverage on Profits
(in thousands)
Firm F Firm V Firm 2F
Sales $15 $16.5 $29.25
Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
O.P(EBIT) $ 5 $ 4 $10.75
Percentage Change in EBIT*
400% 100% 330%
* (EBITt - EBIT t-1) / EBIT t-1
16.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Impact of Operating
Leverage on Profits
• Firm F is the most “sensitive” firm – for it,
a 50% increase in sales leads to a
400% increase in EBIT.
• Our example reveals that it is a mistake to
assume that the firm with the largest absolute
• or relative amount of fixed costs automatically
shows the most dramatic effects of operating
leverage.
• Later, we will come up with an easy way to
spot the firm that is most sensitive to the
presence of operating leverage.
16.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even Analysis

Break-Even Analysis – A technique for

studying the relationship among fixed
costs, variable costs, sales volume, and
profits. Also called cost/volume/profit
analysis (C/V/P) analysis.
• When studying operating leverage,
“profits” refers to operating profits
before taxes (i.e., EBIT) and excludes
debt interest and dividend payments.
16.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even Chart
Total Revenues

Profits
REVENUES AND COSTS

250
($ thousands)

Total Costs
175

100 Fixed Costs

Losses
Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
16.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even
(Quantity) Point
Break-Even Point – The sales volume required
so that total revenues and total costs are
equal; may be in units or in sales dollars.
How to find the quantity break-even point:
EBIT = P(Q) – V(Q) – FC
EBIT = Q(P – V) – FC
P = Price per unit V = Variable costs per unit
FC = Fixed costs Q = Quantity (units)
produced and sold
16.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even
(Quantity) Point
Breakeven occurs when EBIT = 0
Q (P – V) – FC = EBIT
QBE (P – V) – FC = 0
QBE (P – V) = FC
QBE = FC / (P – V)
Unit Contribution Margin
16.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even (Sales) Point
How to find the sales break-even point:
SBE = FC + (VCBE)
SBE = FC + (QBE )(V)
or
SBE*= FC / [1 – (VC / S) ]
* Refer to text for derivation of the formula

16.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even
Point Example

Basket Wonders (BW) wants to

determine both the quantity and sales
break-even points when:
• Fixed costs are $100,000
• Baskets are sold for $43.75 each
• Variable costs are $18.75 per basket

16.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even Point (s)
Breakeven occurs when:
QBE = FC / (P – V)
QBE = $100,000 / ($43.75 – $18.75)
QBE = 4,000 Units

SBE = $100,000/ [1 – (18.75 / 43.75) ]

SBE = $175,000
16.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even
Point Example-2

Basket Wonders (BW) wants to

determine both the quantity and sales
break-even points when:
• Fixed costs are $120,000
• Baskets are sold for $53.75 each
• Variable costs are $17.77 per basket

16.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even Chart
Total Revenues

Profits
REVENUES AND COSTS

250
($ thousands)

Total Costs
175

Fixed Costs
100
Losses
Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD
16.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Degree of Operating
Leverage (DOL)
Degree of Operating Leverage – The
percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
DOL at Q Percentage change in
units of operating profit (EBIT)
output =
Percentage change in
(or sales) output (or sales)
16.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Computing the DOL

Calculating the DOL for a single product

or a single-product firm.

DOLQ units Q (P – V)
=
Q (P – V) – FC

= Q
Q – QBE
16.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Computing the DOL

Calculating the DOL for a

multiproduct firm.

DOLS dollars of S – VC
=
S – VC – FC
sales

EBIT + FC
=
EBIT
16.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Break-Even
Point Example

Juliana wants to determine the degree of

operating leverage at sales levels of
6,000 and 8,000 units. As we did earlier,
we will assume that:
• Fixed costs are $100,000
• Baskets are sold for $43.75 each
• Variable costs are $18.75 per basket

16.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Computing BW’s DOL
Computation based on the previously
calculated break-even point of 4,000 units

6,000
DOL6,000 units = = 3
6,000 – 4,000
8,000 2
DOL8,000 units = =
8,000 – 4,000

16.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Interpretation of the DOL

A 1% increase in sales above the 8,000

unit level increases EBIT by 2%
because of the existing operating
leverage of the firm.

8,000 2
DOL8,000 units = =
8,000 – 4,000

16.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Interpretation of the DOL
Key Conclusions to be Drawn from the
previous slide and our Discussion of DOL
• DOL is a quantitative measure of the “sensitivity”
of a firm’s operating profit to a change in the firm’s
sales.
• When comparing firms, the firm with the highest
DOL is the firm that will be most “sensitive” to a
change in sales.

16.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Application of DOL for
Our Three Firm Example
Use the data in Slide 16–6 and the
following formula for Firm F :
DOL = [(EBIT + FC)/EBIT]

1,000 + 7,000
DOL$10,000 sales = = 8.0
1,000

16.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Application of DOL for
Our Three Firm Example
Use the data in Slide 16–5 and the
following formula for Firm V :
DOL = [(EBIT + FC)/EBIT]

2,000 + 2,000
DOL$11,000 sales = = 2.0
2,000

16.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Application of DOL for
Our Three-Firm Example
Use the data in Slide 16–5 and the
following formula for Firm 2F :
DOL = [(EBIT + FC)/EBIT]

2,500 + 14,000
DOL$19,500 sales = = 6.6
2,500

16.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Application of DOL for
Our Three-Firm Example
The ranked results indicate that the firm most
sensitive to the presence of operating leverage
is Firm F.
Firm F DOL = 8.0
Firm V DOL = 6.6
Firm 2F DOL = 2.0
Firm F will expect a 400% increase in profit from a 50%
increase in sales .

16.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
16.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Financial Leverage

Financial Leverage – The use of

fixed financing costs by the firm.
The British expression is gearing.

• Financial leverage is acquired by

choice.
• Used as a means of increasing the
return to common shareholders.
16.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 EBIT-EPS Break-Even,
or Indifference, Analysis
EBIT-EPS Break-Even Analysis – Analysis of
the effect of financing alternatives on
earnings per share. The break-even point is
the EBIT level where EPS is the same for
two (or more) alternatives.
Calculate EPS for a given level of
EBIT at a given financing structure.
(EBIT – I) (1 – t) – Pref. Div.
EPS =
# of Common Shares
16.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 EBIT-EPS Chart/Analysis

BW has $2 million in LT financing (100%

common stock equity).
• Current common equity shares =
50,000
• $1 million in new financing of
either:
• All C.S. sold at $20/share (50,000 shares)
• All debt with a coupon rate of 10%
16.31
• All P.S. with a dividend rate of 9%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 EBIT-EPS Calculation with
New Equity Financing
Common Stock Equity Alternative
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000
45,000
EAT $350,000 $105,000
Preferred Dividends 0
0* A second analysis using $150,000 EBIT rather than the expected EBIT.
16.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 EBIT-EPS Calculation with
New Debt Financing
Long-term Debt Alternative
EBIT $500,000 $150,000*
Interest 100,000 100,000
EBT $400,000 $ 50,000
Taxes (30% x EBT) 120,000
15,000
EAT $280,000 $ 35,000
Preferred Dividends 0
0* A second analysis using $150,000 EBIT rather than the expected EBIT.
16.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 EBIT-EPS Calculation with
New Preferred Financing
Preferred Stock Alternative
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000
45,000
EAT $350,000 $105,000
Preferred Dividends 90,000
90,000
16.34
* A second analysis using $150,000 EBIT rather than the expected EBIT.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Degree of Financial
Leverage (DFL)
Degree of Financial Leverage – The
percentage change in a firm’s earnings
per share (EPS) resulting from a 1
percent change in operating profit.
DFL at
Percentage change in
EBIT of
earnings per share (EPS)
X dollars =
Percentage change in
operating profit (EBIT)
16.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Computing the DFL

Calculating the DFL

EBIT
DFL EBIT of $X =
EBIT – I – [ PD / (1 – t) ]

EBIT = Earnings before interest and taxes

I = Interest
PD = Preferred dividends
t = Corporate tax rate
16.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What is the DFL for Each
of the Financing Choices?

Calculating the DFL for NEW equity* alternative

DFL $500,000 $500,000

=
$500,000 – 0 – [0 / (1 – 0)]

= 1.00

* The calculation is based on the expected EBIT

16.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What is the DFL for Each
of the Financing Choices?

Calculating the DFL for NEW debt * alternative

DFL $500,000 $500,000

=
{ $500,000 – 100,000
– [0 / (1 – 0)] }
= $500,000 / $400,000

= 1.25
* The calculation is based on the expected EBIT
16.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What is the DFL for Each
of the Financing Choices?
Calculating the DFL for NEW preferred * alternative

DFL $500,000 $500,000

=
{ $500,000 – 0
– [90,000 / (1 – 0.30)] }
= $500,000 / $371,429

= 1.35
* The calculation is based on the expected EBIT
16.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Variability of EPS
DFLEquity = 1.00
Which financing
method will have
DFLDebt = 1.25
the greatest relative
DFLPreferred = 1.35 variability in EPS?
• Preferred stock financing will lead to
the greatest variability in earnings per
share based on the DFL.
• This is due to the tax deductibility of
interest on debt financing.
16.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 1. Similarities and differences between financial
leverage and operating leverage.

16.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-1
Stallings Specialty Paint Company has fixed operating costs of $3 million a year.
Variable operating costs are $1.75 per half pint of paint produced, and the average
selling price is $2 per half pint.
a. What is the annual operating break-even point in half pints (QBE)? In dollars of sales
(SBE)?
b. If variable operating costs decline to $1.68 per half pint, what would happen to the
operating break-even point (QBE)?
c. If fixed costs increase to $3.75 million per year, what would be the effect on the
operating break-even point (QBE)?
d. Compute the degree of operating leverage (DOL) at the current sales level of 16
million half pints.
e. If sales are expected to increase by 15 percent from the current sales position of
16 million half pints, what would be the resulting percentage change in operating
profit (EBIT) from its current position?

16.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-2
Gahlon Gearing, Ltd., has a DOL of 2 at its current production and sales level of
10,000
units. The resulting operating income/profit figure is $1,000.

a. If sales are expected to increase by 20 percent from the current 10,000-unit

sales position, what would be the resulting operating profit figure?

b. At the company’s new sales position of 12,000 units, what is the firm’s “new”
DOL figure?

16.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-3

The Andrea S. Fault Seismometer Company is an all-equity-financed firm. It earns

monthly, after taxes, $24,000 on sales of $880,000. The tax rate of the company is 40
percent. The company’s only product, “The Desktop Seismometer,” sells for $200, of
which $150 is variable cost.

a. What is the company’s monthly fixed operating cost?

b. What is the monthly operating break-even point in units? In dollars?

16.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-4
What would be the effect of the following on the break-even point of the Andrea S.
Fault
Company (Math Problem-3)?
a. An increase in selling price of $50 per unit
b. A decrease in fixed operating costs of $20,000 per month
c. A decrease in variable costs of $10 per unit and an increase in fixed costs of
$60,000 per month

16.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-5
The Crazy Horse Hotel has a capacity to stable 50 horses. The fee for stabling a horse
is $100 per month. Maintenance, depreciation, and other fixed operating costs total
$1,200 per month. Variable operating costs per horse are $12 per month for hay and
bedding and $8 per month for grain.

a. Determine the monthly operating break-even point (in horses stabled).

b. Compute the monthly operating profit if an average of 40 horses are stabled
c. Calculate EAT( Earning after Tax) if the tax rate in 40 percent.

16.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-6
Hi-Grade Regulator Company currently has 100,000 shares of common stock
outstanding with a market price of $60 per share. It also has $2 million in 6 percent
bonds.
The company is considering a $3 million expansion program that it can finance with all
common stock at $60 a share (option 1), straight bonds at 8 percent interest (option 2),
preferred stock at 7 percent (option 3), and half common stock at $60 per share and
half 8 percent bonds (option 4).

a. For an expected EBIT level of $1 million after the expansion program, calculate the
earnings per share for each of the alternative methods of financing. Assume a tax rate
of 50 percent. Which option would you like to go with from the additional financing
plans?

16.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Math Problem-7
DQB Bat Company currently has $3 million in debt outstanding, bearing an interest
rate of 12 percent. It wishes to finance a $4 million expansion program and is
considering three alternatives: additional debt at 14 percent interest (option 1),
preferred stock with a 12 percent dividend (option 2), and the sale of common stock at
$16 per share (option 3). The company currently has 800,000 shares of common stock
outstanding and is in a 40 percent tax bracket.
a. If earnings before interest and taxes are currently $1.5 million, what would be
earnings per share for the three alternatives, assuming no immediate increase in
operating profit?

b. Compute the degree of financial leverage (DFL) for each alternative at the expected
EBIT level of $1.5 million. Comment on your results.

16.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Quiz next Class.

16.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.