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Financial Management ­ MGT201
VU
Lesson 31
OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND
BUSINESS RISK
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topics:
·  Operating Leverage
·  Financial Leverage
·  Concepts of Return on Equity, Break-Even Point and Business Risks
In this lecture we will continue our discussion of capital structure and specifically we will discuss
Operating Leverage, Financial Leverage and the concepts related to Return on Equity, Break-Even
Points and Business Risks. In the last lecture we mentioned that
total stand alone
risk faced by a firm
= Business Risk + Financial Risk
Now, first we focus business risk then later we shall discuss financial risk.
Business Risk (from Operations except Debt):
Business risk stems from the operation and the assets of the firm. These may be caused by:
­  Uncertainty & fluctuations in prices & costs.
­  Specific business & Market Causes.
­  Higher operating leverage (OL = Fixed Cost / Total Cost) that results in:
·  Higher breakeven point
·  Higher but riskier expected return on equity (ROE)
Application of Operating Leverage to Capital Budgeting:
Operating Leverage is the impact of a small change in the sales on the returns on equity. In
other words small decline in sales can cause large decline in ROE (when sales are below breakeven
point). Its formula is
Operating Leverage = Fixed Costs / Total Costs
High operating leverage increases risk due to higher percentage of fixed costs. There are many
industries which are prone to high operating leverage. These are Capital Intensive Industries (i.e. Power
Plant, Cement, Steel, and Textile Spinning), New Product Development, and Research & Development
High Cost Industries (i.e. Pharma, Auto) and industries that need Highly Specialized & Skilled Workers
(i.e. Information Technology, Software House, Semiconductor and Microprocessor, Manufacturers).
Now let us have a look at the sensitivity of Return on Equity to changes in sales. Recall from
the previous lectures, ROE is a measure of overall return of a firm. In case of 100% equity firm the ROE
is the measure of the overall return and any changes or variation in ROE is a measure of risk for that
firm.
First concept that comes within Operating Leverage is Break-even. Break-even represents the
quantity of sales at which operating revenues exactly cover operating costs. In other words the
Breakeven Point is the point or quantity of sales at which Earnings before Interest and Taxes (EBIT) = 0.
Now
EBIT = Operating Revenue - Operating Costs
Recall accounting concepts. Operating costs consists of fixed costs and variable costs. So
EBIT = Operating Revenue - Variable Costs - Fixed Costs
= (PQ) ­ (VQ) ­ F,
where
P= Product Price (Rs.),
Q= Quantity or Number of Units Sold of product,
V= Variable Cost of product per unit (Rs.),
Operating Revenue= Product Price multiplied by Number of Units Sold of product
Variable Costs= Variable Cost of product per unit multiplied by Number of Units Sold of product
F= Fixed Cost (Rs).
As at breakeven point
EBIT = 0
and we have just seen
EBIT = (PQ)-(VQ)-F
so
EBIT= (PQ) ­ (VQ) ­ F = 0.
From this by solving equation we can derive
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Financial Management ­ MGT201
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Q = F / (P - V).
This equation represents the minimum number of units the company must sell in order to cover its
operating costs. We are discussing breakeven as changes in operating leverage will have an impact and
change in breakeven quantity and also will have impact on the likelihood of the company making great
losses. To understand the sensitivity and impact of small changes in sales on ROE, let us have look at a
diagram:
Visualizing Operating Leverage (OL)
Impact on Breakeven Point & Capital Budgeting
Sales REVENUE Line Total COST Line
Revenues &
Technology A:
Costs (Rupees)
Higher OL
Technology A: Larger
OPERATING LOSS
(Cost > Revenue).
Total COST Line
More Risky
Technology B
Fixed Costs A
Fixed Costs B
Breakeven A: Higher.
More Risky
Sales Quantity
(# of Units)
QB*
QA*
Here operating leverage has been graphed. On the Y-axis we have the revenues and costs in
rupees and on X-axis the sales quantity in number of units. Line passing through the origin represents
sales revenue (PQ). Total cost line for two different technologies have also been drawn. Technology A
total cost is represented by a line which is higher up showing higher operating leverage and the
Technology B total cost line is lower with a high slope. Two important consequences to note from this
graph are:
1- For Technology A fixed costs are high so it has higher operating leverage assuming lines shown on
the graph are representatives of total costs of technologies. Impact of technology A with high operating
leverage on EBIT is that technology A has larger operating loss as shown by the left hand side of the
graph. This loss is due to higher total cost than the sales revenue. A company with higher operational
leverage means it has higher % of fixed costs. Whether the company has high or low sales due to
higher % of fixed costs it has high risks of operational losses. That's why companies, businesses,
projects and technologies with higher operating leverages are perceived as more risky as they have more
chances to incur operating losses due to their unavoidable high fixed costs. Higher operating leverage
means greater reduction in EBIT as shown in graph.
2- As operating leverage increases breakeven point also increases i.e. breakeven shifts to the right. In
other words, companies with high operating leverage require more units to be sold to cover their
operating costs.
These are the two ways operating leverage affects the level of risk for a company. The above
discussion of impact of operating leverage on capital budgeting indicate operating leverage affects EBIT.
So, higher operating leverage means chances of falling ROE drastically are higher. Hence, companies
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with higher operating leverage are more risky, their required rate of return is higher, discount rate in
NPV formula is higher and NPV for these companies will be lower calculated for investment decision.
Operating Leverage Application to Capital Structure:
Operating leverage also affects Capital Structure. Companies and technologies with high operating
leverage have higher risks that means they have
·  Higher Betas (CAPM Approach to Cost of Equity Capital)
·  Higher Weighted Average Cost of Capital
·  Also higher average overall rate of return measured in terms of return on equity. This is possible
in case of sales of companies are higher than breakeven point. In this case companies with higher
operating leverages earn higher EBIT.
Therefore, overall impact of operating leverage must consider higher risk and higher return both
provided by companies with high operating leverage. Have a look on the following graph to visualize
the effect of Operating Leverage on risk and return of a particular technology:
Visualizing Operating Leverage (OL)
Impact on ROE & Capital Structure
Technology B: Lower OL:
Low Risk & Low ROE
Technology A: High OL,
High Risk & High ROE.
Risk B
Higher WACC
Risk A
Expected ROE
Expected ROE
= <ROE>B
= <ROE>A
Return on Equity ( ROE)%
On the Y-axis we have the probability and on X-axis the ROE. There are two probability
distributions. One on the left side is tall sharp peak probability distribution that represents technology B
with lower Operating Leverage. It has lower risk and lower average ROE. Other on the right side is
short and flatter that represents technology A with higher OL. It has high risk and higher average ROE.
It also has higher WACC as it has higher required rate of return. Recall probability distribution and risk
theory discussion that risks can be visualized as width or range of probability distributions curves.
Shorter and flatter curve of A shows higher risk. Its average or mean ROE to that of right of B, shows
higher ROE of A.
Now we come to the other component of a firm risk i.e. financial risk.
Financial Risk:
·  Created when Firm takes Loan or Debt or issues Bonds ­ this is Financial Leverage
FL = Debt / Total Assets
·  Increase in Risk faced by Common Stock Holders (or Equity Holders or Owners) when a Firm
takes on more Debt or Financial Leverage.
·  Increase in debt shifts more risk on common stock holders and risk per share increases.
·  Example: Suppose a Firm ABC has Total Assets of Rs.1000 and is 100% Equity based (i.e.
Un-levered). There were 10 equal Owners and 5 of them want to leave. So the Firm takes a
Bank Loan of Rs.500 (at 10%pa Mark-up) and pays back the Equity Capital to the 5 Owners
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who are leaving. Now, half of the Equity Capital has been replaced with a Loan from a Bank
(i.e. Debt). What impact does this have on ROE?
·  Assuming Business Risk is unchanged, and then risk per share rises because Equity is halved.
So, more Risk is transferred to Common Shareholders.
·  Debt Investors (i.e. Lenders and Bond Holders) face minimal risk because
(1) Guaranteed Regular Interest Income and
(2) 1st Claim on Assets in event of Bankruptcy
Financial Leverage (Debt) Increases ROE Risk:
FL is the degree or extent to which a company's total capital is composed of debt. So a company with
80% debt is highly leveraged. Let us take an example of a company moving from 100% equity to 50%
equity and 50% debt to see Impact of Financial Leverage (Loan) on Balance Sheet.
Impact of Financial Leverage (Loan) on Balance Sheet
Un-Levered Firm
Levered Firm
(100% Equity)
(50% Equity - 50% Debt)
Liabilities
Assets
Liabilities
Assets
Debt:  500
Equity: 1000
Equity: 500
Total: 1000
Total:  1000
Total: 100
Total:  1000
Note: Total Assets = Total Liabilities = Debt + Equity
This table shows the capital structure of the firm under the conditions of leverage and no leverage.
Under no leverage its Assets=Equity=1000. But after leverage it has 500 as debt and 500 as equity. It
has converted 500 of equity into debt by taking loan.
·  Increase in Debt increases chances of net loss if seasonal dip causes EBIT to fall below interest
payment.
·  Increase in Debt increases uncertainty in ROE. Range or Spread of Possible future values of
ROE increases. Risk faced by Common Stock Holders Increases.
This can be illustrated by the following example:
Impact of Financial Leverage (Loan) on Income Statement & ROE
Un-Levered
Levered
(100% Equity)
(50% Equity)
Expected EBIT
300
300
Interest (10% of 500)
0
50
EBT
300
250
Tax (30% of EBIT)
90
75
Net Income (NI)
210
175
Expected ROE (=NI/Equity)
210/1000= 21%
175/500=35%
Total Return
210
175+50=225
·
Increase in Debt Improved or Leveraged Up the ROE to 35%
·
Increase in Debt also Increased the Total Return to Investors = NI + Interest. Increased from
Rs.210 to 225 (175+50)
·
So, why not keep adding more Debt? Because, Debt has increased the risk i.e. The Standard
Deviation or Uncertainty of ROE.
·
Total Stand Alone Risk of Firm = Business Risk + Financial Risk
­  Total Stand Alone Risk = Standard Deviation of ROE of Levered Firm
­  Business Risk = Standard Deviation of ROE for Un-levered Firm
Financial Leverage (FL) & Operating Leverage (OL):
Effect of Financial Leverage & Operating Leverage on ROE is Similar:
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Financial Management ­ MGT201
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­
High Operating Leverage: High Fixed Costs so small changes in Quantity Sold cause larger
changes in Net Income & ROE
·  Risky if Firm's Sales < Breakeven Point BUT
·  Multiplies Increase in Mean ROE when Sales > Breakeven
­  High Financial Leverage: High Debt & Interest Payments so small changes in EBIT cause large
changes in Net Income & ROE
·  Risky if Firm's Overall Return is low and can not pay Interest on time but
·  Multiplies Increase in Mean ROE and Total Return (to Equity & Debt Holders) when
Firm's Overall Return is Higher than Cost of Debt
The impact of leverage debt on ROE can be visualized in a graph. For this purpose we need to
consider the following table:
EBIT
Interest EBT
Tax
Net Income ROE
(Rs.50)
(30%)
(=NI/Equity)
Un-Levered
600
0
600
180
420
42%
Firm with
300
0
300
90
210
21%
no debt or 100%
50
0
50
15
35
3.5%
equity
Levered firm
600
50
550
165
385
77%
with debt
300
50
250
75
175
35%
50
50
0
0
0
0%
You see for a levered firm range of ROE is high from 0 to 77% for level of earnings from 50 to
600. For un levered firm this range is very short from 3.5% to 42% for same level of earnings. So for a
company whose sales are low un levered capital structure is safer than a levered one while for a
company with healthy sales growth, levered capital structure provides an opportunity of high ROE.
Visualizing Financial Leverage (FL)
Impact on ROE & Capital Structure
LEVERED (Debt
ROE (%)
& Equity) Firm:
77%
Higher Slope.
ROE more
sensitive to
changes in EBIT
42%
35% = <ROE>L
UN-LEVERED
(100% Equity)
21% = <ROE>UL
Firm. Safer
Capital Structure
3.5%
at Low EBIT's
0%
EBIT (Rs)
50
300
600
The impact of leverage debt on ROE can also be shown in a graph based on probability distributions:
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Financial Management ­ MGT201
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Visualizing Impact of Financial Leverage
on ROE & Capital Structure
Un-Levered (100% Equity):
Lower ROE and Lower Risk.
Levered (Debt & Equity):
Higher ROE but Higher
Risk
Risk also.
Risk
Expected ROE
Expected ROE
<ROE>Un-Levered
<ROE>Levered =
35%
= 21%
Return on Equity ( ROE)%
On the Y-axis we have the probability and on X-axis the ROE. There are two probability
distributions. One on the left side is tall sharp peak probability distribution that represents un levered
firm. It has lower risk and lower average ROE. Other on the right side is short and flatter that represents
levered firm with higher OL. It has high risk and higher average ROE. Recall probability distribution
and risk theory discussion that risks can be visualized as width or range of probability distributions
curves. We shall discuss these graphs and financial leverage in detail in next lecture.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios