Curriculum 4: Module 3: Measures of Leverage

Definitions/Components: (Bankruptcy protection to creditors and shareholder) Reorganization (Chapter 11) Liquidation (Chapter 7)

- Reorganization (Chapter 11): provides the company temporary protection from creditors so that it can reorganize its capital structure and emerge from bankruptcy as a going concern. - Liquidation (Chapter 7) allows for an orderly settlement of the creditors' claims. In this category of bankruptcy, the original business ceases to exist.

Intro: Leverage

- refers to a company's use of fixed costs in conducting business. Fixed costs include: Operating cost (e.g., rent and depreciation). Financial costs (e.g., interest expense). - Fixed costs are referred to as leverage because they support the company's activities and earnings --------------------------------------------------------- Leverage is affected by a company's cost structure: Fixed Cost (same irrespective of the level of production and sales: depreciation and interest expense) Variable Cost (vary with the level of production and sales: raw materials costs and sales commissions)

L1R37TB-AC028-1605 Penang Langkawi Number of units produced and sold 300,000 330,000 Standard deviation of unit sales 30,000 19,800 Sales price per unit MYR 25,000 MYR 30,000 Variable cost per unit MYR 10,000 MYR 17,000 Fixed operating cost MYR 2,500,000,000 MYR 2,000,000,000 Interest expense MYR 1,000,000,000 MYR 1,500,000,000 If unit sales increase by 10 percent, the expected change in operating income for Penang Autos will be closest to: 10.0 percent. 20.0 percent. 22.5 percent

22.5 percent

L1R37TB-AC031-1605**(great question!) Sheena Kereta, CFA, is a financial analyst specializing in the valuation of auto companies. She has spent the last week gathering information on two competing auto manufacturers in Malaysia. Each company manufactures a single low-cost model and sells it in a highly competitive market. The sales price and units sold vary due to intense competition in the low-cost segment. Sheena has summarized the information in the table below. Penang Langkawi Number of units produced and sold 300,000 330,000 Standard deviation of unit sales 30,000 19,800 Sales price per unit MYR 25,000 MYR 30,000 Variable cost per unit MYR 10,000 MYR 17,000 Fixed operating cost MYR 2,500,000,000 MYR 2,000,000,000 Interest expense MYR 1,000,000,000 MYR 1,500,000,000 At unit sales of 300,000, Penang Autos' degrees of operating and financial leverage are, respectively: A 2.25 and 2.00 B 2.00 and 2.25 C 2.00 and 2.00

A 2.25 and 2.00

L1CF-TBP219-1504 Consider the following statements about the effect of financial leverage on return on equity: I An introduction of financial leverage into the capital structure of a company II makes the return on equity more volatile. For a profitable company, the use of financial leverage can help a company increase the level of return on equity. Which of the following statements are correct? I only. II only. Both I and II.

Ans: Both I and II. The introduction of debt to a company's capital structure increases the volatility of the return on equity. It also has the ability to increase the amount of return on equity for profitable companies.

L1R37TB-AC002-1605 If the degree of total leverage is equal to the degree of financial leverage, then which of the following is most likely? Fixed operating costs are zero. Degree of financial leverage is 1. Fixed financial costs are zero.

Ans: Fixed operating costs are zero. DTL = DOL × DFL If DTL = DFL, then DOL = 1. When fixed operating costs are zero, degree of operating leverage is equal to 1. When fixed financial costs are zero, degree of financial leverage is equal to 1.

L1R37TB-AC047-1605 mePhone and uPhone, two cell phone manufacturers, have estimated sales of 10,000 units each. If the two companies have identical operating risk but different financial risk, they are most likely to have identical sensitivity of: net income to changes in unit sales. net income to changes in operating income. operating income to changes in unit sales. net income to changes in unit sales. net income to changes in operating income. operating income to changes in unit sales.

Ans: operating income to changes in unit sales. The two companies most likely have the same degree of operating leverage given that the operating risk is identical.

Calculation: Company's Breakeven Points (BE) - company's breakeven point occurs at the number of units produced and sold at which its net income equals zero. (Commit these formulas into memory)

Breakeven point for a company occurs when: PQ = V*Q + F + C --------------------------------------------- Breakeven number of units: QBE= (F + C) / (P − V) P = Price per unit Q = Number of units produced and sold V = Variable cost per unit F = Fixed operating costs C = Fixed financial cost

Calculation: Degree of Financial Leverage (DFL) - Financial risk can be measured as the sensitivity of cash flows available to owners to changes in operating income, known as the degree of financial leverage (DFL). (Commit these formulas into memory)

DFL: = Percentage change in net income / Percentage change in operating income or = [Q(P−V) − F] / [Q(P−V) − F − C] Q = Number of units sold P = Price per unit V = Variable operating cost per unit F = Fixed operating cost** C = Fixed financial cost** t = Tax rate Note: + The factor that adjusts for taxes (1− t) cancels out. The DFL is not affected by taxes. + Looking at the formula for DFL you should realize that if there are no interest costs, DFL would equal one. This implies that if there are no interest costs, there would be no financial leverage.

Calculation: Degree of Operating Leverage (DOL) - to examine a company's sensitivity of operating income to changes in unit sales (Commit these formulas into memory)

DOL: = Percentage change in operating income / Percentage change in units sold or = Q × (P−V) / Q × (P−V)−F Q = Number of units sold P = Price per unit V = Variable operating cost per unit F = Fixed operating cost*** **Q × (P - V) = Contribution margin (the amount that units sold contribute to covering fixed costs)*** **(P - V) = Contribution margin per unit*** Interpretation: Let's say Blue Horizon company DOL is 1.65%. A 1% change in units sold will result in a 1.625% change in Blue Horizons' operating income.

Calculation: Degree of Total Leverage (DTL) - looks at the combined effect of operating and financial leverage. It measures the sensitivity of net income to changes in units produced and sold. (Commit these formulas into memory)

DTL: = Percentage change in net income / Percentage change in the number of units sold or = DOL×DFL or = Q × (P−V)/ [ Q(P−V) − F − C ] Q = Number of units produced and sold P = Price per unit V = Variable operating cost per unit F = Fixed operating cost*** C = Fixed financial cost*** Interpretation: Let's say Blue Horizon company DOL is 1.65%. implies that a 1% change in the number of units sold will change net income by 1.65% (check L1R37TB-BW003-1612*)

L1R37TB-AC034-1605 If a firm's degree of operating leverage is 2.0, then a one percent: increase in unit sales will result in a two percent increase in net income. decrease in unit sales will result in a two percent decrease in operating income. increase in unit sales will result in a two percent decrease in EBIT.

Degree of operating leverage is a measure of sensitivity of operating income (EBIT) to changes in sales.%Δ EBIT=DOL×%Δ Sales=2.0×−1.0%=−2.0%

L1R37TB-BW003-1612* Ingram Manufacturing expects to increase its sales by 40% based on current consumer trends and preferences. Based on its prior year's income statement, Ingram has a degree of operating leverage of 1.87 and a degree of financial leverage of 1.16. By how much percentage change in its earnings before tax should Ingram expect this year? 24.81% 64.48% 86.77%

The third choice is correct. % change in EBT = DOL × DOF × % Change in sales % change in EBT = 1.87 × 1.16 × 40% = 86.768%

Definitions/Components: important for analysts to understand a company's use of leverage for the following reasons: (quickly scan over, common sense, understand the general concept and you're good to go)

+ Leverage increases the volatility of a company's earnings and cash flows, thereby increasing the risk borne by investors in the company. [ + more significant the use of leverage by the company, the more risky it is, therefore the higher the discount rate that must be used to value the company. + highly leverage risks significant losses during economic downturns.

Definitions/Components: Degree of Financial Leverage (DFL)'s Takeaway (Quickly scan through, don't get stuck on here. The important thing is the DFL formula)

+ The larger the proportion of debt in a company's capital structure, the greater the sensitivity of net income to changes in operating income, and therefore the greater the company's financial risk. + Degree of financial leverage is usually determined by the company's management

Quick Recap: Business risk, Sales risk, and Operating risk. [From C4 Module 1]

- Business risk refers to the risk associated with a company's operating earnings. [From C4 Module 1] + Business risk can be broken down into sales risk and operating risk. (Largely affected by its industry) + Sales risk: The uncertainty associated with total revenue. Revenue is affected by economic conditions, industry dynamics, government regulation, and demographics. + Operating risk: ... risk associated with a company's operating cost structure is referred to as operating risk Ex: As shown earlier, a company that has a greater proportion of fixed costs in its cost structure has greater operating risk.

Definitions: Financial risk

- Financial risk refers to the risk associated with how a company chooses to finance its operations. If a company chooses to issue debt or acquire assets on long-term leases, it is obligated to make regular payments when due - the higher the amount of fixed financial costs taken on by a company, the greater its financial risk.

L1R37TB-AC050-1605 CheapPhones Inc. sells half a million units of its low-cost phone at $100 per unit. Variable costs are $70 per unit and fixed operating costs are $300,000. If the company has no debt, the dollar sales at the operating breakeven and breakeven points are, respectively: $10,000 and $10,000. $1,000,000 and $1,000,000. $1,000,000 and $50,000,000.

$1,000,000 and $1,000,000. (I had trouble with this question, look over the answer in the binder if you need to)

Definitions/Components: Degree of Operating Leverage (DOL)'s Takeaway (All of them are based on the understanding of math and logics behind DOL formula, the better understanding you have, the better clarification of these takeaway)(Quickly scan through, don't get stuck on here. The important thing is the DOL formula)

+ DOL is different at different levels of sales. If the company is making operating profits(income), the sensitivity of operating income to changes in units sold decreases at higher sales volumes (in units). + DOL is negative when operating income (the denominator in the DOL equation) is negative, and is positive when the company earns operating profits. + Operating income is most sensitive to changes in sales around the point where the company makes zero operating income. + DOL is undefined when operating income is zero.

Testbank:

M3L1: L1R37TB-AC031-1605** L1R37TB-BW010-1612* L1R37TB-BW003-1612* L1R37TB-AC050-1605** L1CF-TBP219-1504* L1R37TB-AC047-1605 (doing more in the future)

Calculation: Operating Breakeven Point - At this point, revenues equal operating costs (Commit these formulas into memory)

PQ(obe) = V*Q(obe) + F Q(obe) = F/ (P−V) **more important formula in obe formulas) or Q(obe) = (Total fixed operating costs / Contribution margin per unit)