Capital Structure and the Effects of Leverage

Class 7 May 25&26 , 2015

Operating, Financial and Total Leverage

Capital structure and the effects of leverage:

Leverage occurs whenever fixed costs are incurred to support the variable amounts of revenues or cash inflows. Leverage is a source of risk for firms; it impacts both total risk and systematic risk. Since firms can have both fixed operating costs and fixed financing costs, there are two types of leverage that can impact an organization – operating and financial leverage. The net result is that leverage will magnify changes in a firm’s financial results.

The firm’s capital structure is the result of the interaction of many different factors. One factor is the business risk to which the firm is exposed. Other things being equal, the more business risk the firm has, the less financial risk it wants to incur.

Business risk

Business risk deals with the risk inherent in the actual operations of a firm. Every firm is exposed to a certain degree of risk because of the nature of the business. Common sources of business include:

Sensitivity of prices to general economic conditions

Degree of competition facing the firm

Uncertainty surrounding the input prices

Ability of the firm to adjust output to changes in market conditions.

Measurement:

-standard deviation of EBIT (the variability in the firm’s earnings before interest and tax)

Business risk is a direct function of the firm’s accumulated investment decisions (capital budgeting projects).

-Business risk is composed of both operating risk and sales risk.

•Sales risk is the uncertainty associated with the number of units produced and sold, as well as the sales price.

•Operating risk is the risk associated with the mix of variable and fixed operating expenses.

-Operating risk is the sensitivity (i.e., elasticity) of operating earnings to changes in unit sales.

•Operating risk affects operating earnings (EBIT).

Operating leverage:

        -is the degree to which a project or firm is committed to fixed production costs (i.e. rent, labor, executive salaries or office administration etc). Operating leverage is highest in companies that have a high proportion of fixed operating costs in relation to variable operating costs.

-Operating leverage is the responsiveness of operating cash flow (OCF) or earnings before interest and taxes (EBIT) to fluctuations in the company’s sales (or quantity sold).

-The higher the proportion of fixed costs, the greater the % change in EBIT as a result of a % change in sales. As a result, a high degree of operating leverage implies that a small change in sales results in a large change in EBIT

-A high degree of operating leverage will result in a higher break-even point.

The degree of operating leverage is defined as the % change in EBIT that results from a % change in units sold or sales

DOL = % change in EBIT

                             % change in Sales

This can also be expressed in a formula developed for calculating the degree of operating leverage at any base level of sales:

                [pic 1] Don’t forget: Amortization & Depreciation are considered fixed costs.

Note: The per unit contribution margin is the difference between the sales price and the variable cost per unit. This difference is available to cover fixed operating costs.

-Overall, for all units sold, the contribution margin is the difference between total revenues and variable operating costs.

Since fixed costs do not change with sales, they make good situations better and bad situations worse i.e. they “lever” results.

Example 1:  If Thirsty’s Inc. sells 20,000 T-Shirts, their operating cash flow (EBIT) will be $9,000 and fixed costs will be $45,000.

1. What is the DOL for Thirsty’s?
2. If the number of T-Shirts sold increases by 10%, what is the percentage change in operating cash flows (EBIT)?

Example 2: The Slumber Hat Company is evaluating the replacement of its’ current operating facilities. Under current conditions the company manufactures and sells $2,000,000 worth of hats at a price of $5 per hat. The cost of goods sold during the same period was $500,000 and fixed costs were $2.50 per hat.

The current production facilities have a maximum production capacity of 500,000 units per year. The new facilities will result in the variable costs declining to $1.20 per unit; however fixed costs will rise to $1,200,000.

1. Construct the operating statement for the company for each of the plans.

b) WHAT EFFECT WOULD A 10% INCREASE IN SALES HAVE ON THE EBIT OF THE TWO PLANS?