Chapter 5 Operating Financial Leverage

financial leverage

A measure of the amount of debt used in the capital structure of the firm.

Degree of Financial Leverage (DFL)

A measure of the impact of debt on the earnings capability of the firm. The percentage change in earnings per share is divided by the percentage change in earnings before interest and taxes at a given level of operation.

Degree of Operating Leverage (DOL)

A measure of the impact of fixed costs on the operating earnings of the firm. The percentage change in operating income is divided by the percentage change in volume at a given level of operation.

Degree of Combined Leverage (DCL)

A measure of the total combined effect of operating and financial leverage on earnings per share. The percentage change in earnings per share is divided by the percentage change in sales at a given level of operation.

operating leverage

A reflection of the extent to which fixed assets and fixed costs are utilized in the business firm.

What factors would cause a difference in the use of financial leverage for a utility company and an automobile company?

A utility company would have a more demand. The utility company could calculate future profits with more certainty and therefore increase its financial leverage at a lower risk of incurring the costs of financial distress. An automobile company on the other hand would have more risk, product competition could result in a slump in car sales and therefore volatility in the profit forecast. The automobile company would therefore choose lower financial leverage.

What role does depreciation play in break even analysis based on accounting flows? Based on Cash flows? What perspective is longer term in nature?

Accounting Flows: depreciation is considered part of fixed costs. Cash Flows: it is eliminated from fixed costs Accounting flows perspective is longer term in nature because we must consider problems of equipment replacement.

Discuss the limitations of financial leverage

Discuss the limitations of financial leverage. Common stockholders may drive down the price of stock.

How does the interest rate on new debt influence the use of financial leverage

Higher the interest rate on new debt, the less financial leverage the firm has

Explain how the break even point and operating leverage are affected by the choice of manufacturing facilities (labor intensive vs capital intensive)

Labor Intensive: low fixed costs and low break-even point. Little impact of operating leverage and little magnification of profits as volume increases. Capital Intensive Firm: higher break-even point and increase in operating leverage as volume increases.

Explain how combined leverage brings together operating income and earnings per share

Operating leverage primarily affects the operating income of the firm. Financial leverage takes over and determines overall impact on earnings per share.

explain how operating leverage decreases as a company increases sales and shifts away from the break even point?

Percentage change in operating income as a result of percentage change in unit volume diminishes. As you move to Increasingly higher levels of operating income, the percentage change from the higher base is likely to be less.

contribution margin

The contribution to fixed costs from each unit of sales. The margin may be computed as price minus variable cost per unit.

When you are considering two different financing plans, does being at the level where earnings per share are equal between the two plans always mean you are indifferent as to which plan is selected?

The point of equality only measures indifference based on EPS. Two plans that have eps may call for different p/e ratios

combined leverage

The total or combined impact of operating and financial leverage.

Discuss the various uses for break-even analysis

To determine how much in additional sales are necessary to cover a new expenditure or program. Determine how much in additional sales are necessary to reach a Net Profit Target

leverage

the use of fixed-charge items with the intent of magnifying the potential returns to the firm