Chapter 07 {Final Energy Financial Management}.Doc

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stopgap, paying the premiums for four or five months until they find a health

insurance plan more affordable or more appropriate for their individual needs.

Have you lined up your lines of credit in advance? The time to get approval for a

loan is when you don't need one. If you have a lot of equity in your home, it's

currently possible to set up a home equity line of credit that will let you borrowmoney at 1 percentage point over the prime rate or less. Banks and other lenders

are, for obvious reasons, more willing to make loans to someone who has had a job

with a steady paycheck for several years than to someone who has just quit to enter

the wild, wonderful world of self-employment. If you have an excellent credit rating,

you can probably get a home equity or other secured loan with a minimal amount of

paperwork. Once you're self-employed, you'll probably have to provide at least your

most recent tax return and other documentation before getting approval.

Are you covered against not being able to run your business? You may have some

disability insurance through your current employer. The problem is, disabilityinsurance (unlike health insurance) usually cannot be kept or transferred to an

individual policy when you leave your job. To protect yourself, get your own

disability policy while you are still employed. Once you have the policy established

and are paying the premiums, you should be able to keep the policy when you go out

on your own. (Check with your insurance agent to make sure that any policy will

remain in force after you leave a job.) An added bonus: While the hope is that you

never need to collect on a disability policy, benefits you receive on a policy you paid

for yourself are free of federal income tax. Benefits on a policy paid for by your

employer are taxable.

7.2 Leverage

Operating leverage results from the presence of fixed operating costs in a firm's

income stream. The extent of the presence of fixed operating costs in a firm's income

stream is measured by the degree of operating leverage (DOL).

Percentage Change in Earnings Before Interest and Taxes

(EBIT)DOL =

Percentage Change in Sales

Financial leverage results from the presence of fixed financial costs in a firm's

income stream. The extent of the presence of fixed financial costs in a firm's income

stream is measured by the degree of financial leverage (DFL).


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Percentage Change in Net Income (NI)

DFL =Percentage Change in Earnings Before Interest and Taxes

(EBIT)

Firm's often have both operating and financial leverage. This total or combined

leverage results from the presence of both fixed operating and financial costs in a

firm's income stream. Combined leverage is measured by the degree of combined

leverage (DCL).

Percentage Change in Net Income (NI)DCL =

Percentage Change in Sales

Notice that DCL = DFL DOL

7.3 Degree of Leverage

A leverage ratio that summarizes the combined effect the degree of operating

leverage (DOL), and the degree of financial leverage has on earnings per share(EPS), given a particular change in sales. This ratio can be used to help determine

the most optimal level of financial and operating leverage to use in any firm. For

illustration, the formula is:

This ratio can be very useful, as it summarizes the effects of combining both

financial and operating leverage, and what effect this combination, or variations ofthis combination, has on the corporation's earnings. Not all corporations use both

operating and financial leverage, but if they do, then this formula can be used.

Firms that have greater degrees of leverage have greater levels of fixed costs. And as

such, they tend to have greater break-even points than do firm's that do not have

leverage. The advantage of having greater degrees of leverage is that as a firm's


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sales volume increases beyond the break-even point, its margins improve. The

disadvantage of having greater degrees of leverage is that because the break-even

point is higher, which means that the firm is required to achieve a higher sales

volume in order to reach the break-even point. In good times when sales are high, a

higher degree of leverage allows a firm to maximize profits. In bad times when sales

are not as good, the firm is able to minimize its losses by having a lower degree of

leverage.

Example:

In the example below, a firm's projected EBIT under two very different cost

structures.

Income Statement High Leverage Low Leverage

Sales $ 100,000 100 % $ 100,000 100 %

Variable Operating Costs 20,000 20 40,000 40

Contribution Margin 80,000 80 60,000 60

Fixed Operating Costs 40,000 40 20,000 20

EBIT $ 40,000 40 % $ 40,000 40 %

Notice the firm experiences the same level of sales, while it has very different cost

structures. Now notice what happens to the firm under each option when their sales

decrease to $50,000.


Sales $ 50,000 100 % $ 50,000 100 %



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EBIT $ 0 0 % $ 10,000 20 %

When the sales drop to $50,000, the high leverage option declines to its break-even

point while the low leverage option minimizes the loss. Now notice what happens to

the firm's sales increase to $150,000.


Sales $ 150,000 100 % $ 150,000 100 %




EBIT $ 80,000 53 % $ 70,000 47 %

When a firm's sales increase, the cost structure option with the higher degree of

leverage is able to maximize the firm's profit

In finance, leverage (or gearing) is using given resources in such a way that thepotential positive or negative outcome is magnified. It generally refers to borrowing.

1. The use of various financial instruments or borrowed capital, such as margin, toincrease the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly moredebt than equity is considered to be highly leveraged.

Leverage helps both the investor and the firm to invest or operate. However, itcomes with greater risk. If an investor uses leverage to make an investment and the


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investment moves against the investor, his or her loss is much greater than itwould've been if the investment had not been leveraged - leverage magnifies bothgains losses. In the business world, a company can use leverage to try to generateshareholder wealth, but if it fails to do so, the interest expense and credit risk ofdefault destroys shareholder value.

1. Leverage can be created through options, futures, margin and other financialinstruments. For example, say you have $1,000 to invest. This amount could beinvested in 10 shares of Microsoft stock, but to increase leverage, you could investthe $1,000 in five options contracts. You would then control 500 shares instead ofjust 10.

2. Most companies use debt to finance operations. By doing so, a company increasesits leverage because it can invest in business operations without increasing its equity.For example, if a company formed with an investment of $5 million from investors,the equity in the company is $5 million - this is the money the company uses to

operate. If the company uses debt financing by borrowing $20 million, the companynow has $25 million to invest in business operations and more opportunity toincrease value for shareholders.

Leverage means to lever or raise. Mechanical leverage means that by using alever bar, one can power to do a large work by applying even a small force.Similarly, in financial management leverages means that by use of certain fixedcosts, the firm increases manifold or levers up its profitability.

There are two types of leverages:

Operating Leverages Financial Leverages

7.3.1 Operating Leverages

Operating Leverage means that by use of fixed operating cost, the profitability ofthe business enterprise is increased. In other words, by use of fixedproduction/manufacturing/operating cost the business enterprise increases itsoperating profits (EBIT).

Manufacturing costs are of two types:

Fixed cost (F.C)

Variable cost (V.C)

Fixed cost not change as volume of production (output) changes upto a certain pointof production volume. Beyond this limit point all cost becomes variable in nature.Under this limit point of production quantity fixed cost does not change with change


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in production output remains constant of fixed. E.g. depreciation, insurance, somepart of cost management etc.

Variable cost includes cost of raw material, direct labour, selling commissions, etc.they vary proportionately with production output, i.e. as volume increases the

variables cost also increases and vice-versa.

Due to presence of Fixed cost, a very small in production output causes aproportionately large change in profitability of the business enterprises. In otherwords, any business enterprise having Operation Leverage (Fixed Operating cost)will show a large change in operating profits (EBIT) by causing even a smallproportionate change in sales. Any change in sales will result in proportionatechange in production volume i.e. increases in sales will results in increases inproduction output. Thus productions cost (VC+FC) will increases,

7.4 Break Even Analysis

One of the most common tools used in evaluating the economic feasibility of a new

enterprise or product is the break-even analysis. The break-even point is the point

at which revenue is exactly equal to costs. At this point, no profit is made and no

losses are incurred. The break-even point can be expressed in terms of unit sales or

dollar sales. That is, the break-even units indicate the level of sales that are required

to cover costs. Sales above that number result in profit and sales below that number

result in a loss. The break-even sale indicates the dollars of gross sales required to

break-even.

It is important to realize that a company will not necessarily produce a product justbecause it is expected to breakeven. Many times, a certain level of profitability or

return on investment is desired. If this objective cannot be reached, which may

mean selling a substantial number of units above break-even, the product may not

be produced. However, the break-even is an excellent tool to help quantify the level

of production needed for a new business or a new product. Break-even analysis is

based on two types of costs: fixed costs and variable costs. Fixed costs are overhead-

type expenses that are constant and do not change as the level of output changes.

Variable expenses are not constant and do change with the level of output. Because

of this, variable expenses are often stated on a per unit basis.

Once the break-even point is met, assuming no change in selling price, fixed and

variable cost, a profit in the amount of the difference in the selling price and the

variable costs will be recognized. One important aspect of break-even analysis is

that it is normally not this simple. In many instances, the selling price, fixed costs or

variable costs will not remain constant resulting in a change in the break-even.. And

these changes will change the break-even. So, a break-even cannot be calculated


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only once. It should be calculated on a regular basis to reflect changes in costs and

prices and in order to maintain profitability or make adjustments in the product

line.

Break even analysis measures the level of sales necessary to cover up total operating

costs (fixed costs and variables cost). I.e, the point of sales revenue that equals the

total operating cost (FC+VC) of the firm.

At break even point the firm neither incurs any profits nor any loss. Thus at B.E.P.,

the EBIT (operating profits) is ZERO for a given firm.

EBIT = REVENUE COST

Break even analysis is one of the means to study the relationship between total

operating cost and total revenue for a given firm. .

A firm's break-even point occurs when at a point where total revenue equals total

costs.

Break-even analysis depends on the following variables:

Selling Price per Unit: The amount of money charged to the customer for each unit

of a product or service.

Total Fixed Costs: The sum of all costs required to produce the first unit of a

product. This amount does not vary as production increases or decreases, until new

capital expenditures are needed.

Variable Unit Cost: Costs that vary directly with the production of one additional

unit.

Total Variable Cost The product of expected unit sales and variable unit cost, i.e.,

expected unit sales times the variable unit cost.

Forecasted Net Profit: Total revenue minus total cost. Enter Zero (0) if you wish to

find out the number of units that must be sold in order to produce a profit of zero

(but will recover all associated costs)

Each of these variables is interdependent on the break-even point analysis. If any of

the variables changes, the results may change.


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Total Cost: The sum of the fixed cost and total variable cost for any given level of

production, i.e., fixed cost plus total variable cost.

Total Revenue: The product of forecasted unit sales and unit price, i.e., forecasted

unit sales times unit price.

Break-Even Point: Number of units that must be sold in order to produce a profit of

zero (but will recover all associated costs). In oth1er words, the break-even point is

the point at which your product stops costing you money to produce and sell, and

starts to generate a profit for your company.

One may use the JavaScript to solve some other associated managerial decision

problems, such as:

setting price level and its sensitivity

targeting the "best" values for the variable and fixed cost combinations determining the financial attractiveness of different strategic options for

your company

The graphic method of analysis (below) helps you in understanding the concept of

the break-even point. However, the break-even point is found faster and more

accurately with the following formula:

And EBIT = QS - QV FC


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S = Sales Price / Unit

V = Variables Cost / Unit

Q = Production Quantity at normal Times

FC = Fixed Cost

At B.E.P. the EBIT of the given firm is zero

Hence EBIT = Q*S Q*V FC = 0

Where Q* is production quantity at B.E.P. from the above equation we have

Q* (S V) = FC

Q*(B.E.P.) = FC/(S V)

Now S-V is contribution margin (CM) for a given firm.

Hence we can rewrite the above equation as Q* = FC/CM

For a given firm we have fixed cost of Rs. 2, 00,000/-. Selling price is Rs. 100 / perunit and variables cost is 75 Rs. 100 / per unit and variables cost is 75 Rs. Per unit.Calculate the B.E.P. quantity.

Solution.

B.E.P. (Qty) = 2, 00, 000 / 100-75 = 8000 units

Similarly we can calculate B.E.P. (sales). It is amount of sales that is able to covertotal operating cost of the firm.

S* = FC + VC*

FC = Fixed cost

VC* = Variables cost at B.E.P.

S* = Sales at B.E.P.

Here in this equation we have two unknowns, namely S* and VC*. So to solve theabove equation we can rewrite it as.

*

*

** S

S

VCFCS

+=


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As ratio of VC*/S* is constant at B.E.P., we can rewrite this again as VC/S.

Hence SS

VCFCS

+=

* on solving the above equation we getSVC

FCS

=

1

*

Thus, if a firm operates much above its BEP the sensitivity of operations profits tochange in output (sales) measured by degree of operating leverage, decreases. Themultiplier effect of fixed costs on operating profits decreases as firm moves furtheraway from break even point.

SVC

FCBEPS

=

1)(

*

Operating leverage reflects the extent to which fixed assets and associated fixedcosts are utilized in the business. Degree of operating leverage (DOL) may be

defined as the percentage change in operating income that occurs as a result of apercentage change in units sold. To the extent that one goes with a heavycommitment to fixed costs in the operation of a firm, the firm has operatingleverage.

Operating leverage is a measure of the extent to which, fixed operating costs are being

used in an organization.

It is greatest (largest) in companies that have a high proportion of fixed operating costs

in relation (proportion) to variable operating costs. This type of company is using

more fixed assets in the operation of the company.

Conversely, operating leverage is lowest in companies that have a low proportion of

fixed operating costs in relation to variable operating costs.

Firms with large amounts of fixed operating costs have high break-even points and

high operating leverage. Variable cost in these firms tends to be low and both the

contribution (CM) and unit contribution (UC) margin is high.

Formula(s) for calculating Operating leverage:

It is measured by % change in Operating Profit (EBIT) due to 1% change in sales

(output).

Degree of Operating Leverage =Percent Change in Operating Income

Percent Change in Sales

or


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Degree of Operating Leverage =Contribution Margin

Earnings Before Interest and Taxes

or

Degree of Operating Leverage =

=DOLTotalSales TotalVariableCost

TotalSales TotalVariableCost Total OperatingFixedCost

Implications:

1. A firm with a high break-even point is more risky than one with a low Break-even point. In periods of increasing sales, operating income (OI or EBIT) of theleveraged firm tends to increase rapidly. This increase in OI (EBIT) is thepay-off for being more risky. But in periods of decreasing sales, operating

income of the firm tends to decrease rapidly, that is the risk.2. Firms with small amounts of fixed operating costs have low break-even points

and are therefore less risky and have low operating leverage. Variable costs inthese firms tend to be high and both the CM and UC is low. In periods ofincreasing sales, operating income (EBIT) for these firms tends to increaseslowly. But in periods of decreasing sales, Operating income will tend todecrease slowly making the firm less risky.

3. In conclusion, if a company has high operating leverage, then the operatingincome (OI or EBIT) will become very sensitive to changes in sales volume.Just a small percentage (%) chance in sales can yield (produce) a largepercentage change in Operating Income. A Company with low operating

leverage the reverse is true.

Operating leverage is extent to which a company's costs of operating are fixed (rent,insurance, executive salaries) as opposed to variable (materials, direct labor). In atotally automated company, whose costs are virtually all fixed, every dollar ofincrease in sales is a dollar of increase in operating income once the Breakeven Pointhas been reached, because costs remain the same at every level of production. Incontrast, a company whose costs are largely variable would show relatively littleincrease in operating income when production and sales increased because costs andproduction would rise together. The leverage comes in because a small change insales has a magnified percentage effect on operating income and losses. The degree

of operating leverage-the ratio of the percentage change in operating income to thepercentage change in sales or units sold-measures the sensitivity of a firm's profitsto changes in sales volume. A firm using a high degree of operating leverage has abreakeven point at a relatively high sales level.

7.4 Financial leverage


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Financial leverage is debt in relation to equity in a firm's capital structure-its Long-Term Debt (usually bonds), Preferred Stock and Shareholders' Equity -measuredby the Debt-To-Equity Ratio. The more long-term debt there is, the greater thefinancial leverage. Shareholders benefit from financial leverage to the extent thatreturn on the borrowed money exceeds the interest costs and the market value of

their shares rises. For this reason, financial leverage is popularly called trading on the equity. Because leverage also means required interest and principal paymentsand thus ultimately the risk of default, how much leverage is desirable is largely aquestion of stability of earnings. As a rule of thumb, an industrial company with adebt to equity ratio of more than 30% is highly leveraged, exceptions being firmswith dependable earnings and cash flow, such as electric utilities.

Financial leverage takes the form of a loan or other borrowings (debt), the proceedsof which are reinvested with the intent to earn a greater rate of return than the costof interest. If the firm's return on assets (ROA) is higher than the interest on theloan, then its return on equity (ROE) will be higher than if it did not borrow. On the

other hand, if the firm's ROA is lower than the interest rate, then its ROE will belower than if it did not borrow. Leverage allows greater potential return to theinvestor than otherwise would have been available. The potential for loss is alsogreater because if the investment becomes worthless, not only is that money lost, butthe loan still needs to be repaid.

Margin buying is a common way of utilizing the concept of leverage in investing. Anunleveled firm can be seen as an all-equity firm, whereas a levered firm is made upof ownership equity and debt. A firm's debt to equity ratio (measured at marketvalue or book value, depending on the purpose of the analysis) is therefore anindication of its leverage. This debt to equity ratio's influence on the value of a firm

is described in the Modigliani-Miller theorem. As is true of operating leverage,degree of financial leverage measures the effect of a change in one variable onanother variable. Degree of financial leverage (DFL) may be defined as thepercentage change in earnings (Earnings per share) that occurs as a result of apercentage change in interest and taxes.

Financial leverage is the extent to which debt (liability) is used in the Capital

Structure (financing) of the firm. Capital Structure refers to the relationship

between assets, debt (liability) and equity. The more debt a firm has relative to

equity the greater the financial leverage (these firms have a higher Debt to Asset

ratios).

Example :

Let us say both companies have the following capital structure:

Company A Company B


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Debt (10%) 100,000 Debt (10%) 40,000

Sh. Equity (AED 10 par) 40,000 Sh. Equity (AED 10 par) 100,000

--------- ----------

(4,000 shares) (10,000 shares)

Total Capital 140,000 Total Capital 140,000

Substantial use of debt will place a great burden on the firm at low levels of

profitability (low EBIT, since interest must be paid). However, it will also help to

magnify (enlarge) increases in earning per share (EPS) as the EBIT or operating

income increases.

Degree of Financial Leverage =Percent Change in Earnings Per Share

Percent Change in Operating Income

or

Degree of Financial Leverage =Earnings Before Interest and Taxes

Earnings Before Interest and Taxes Interest

Implications

1. Financial leverage can be very useful to a firm if properly used under the rightconditions. For firms in industries that have a degree of stability and/or show

growth, the use of debt is recommended because of the positive aspects offinancial leverage.BUT...

2. As a firm increases the use of debt in its capital structure, creditors (lenders)will perceive a greater financial risk in lending money to the firm and thereforemay charge a higher interest rate which may lower earning before tax (EBT).These lenders will perhaps place other restrictions on the firm. Stockholdersmay become concerned with the risk to EPS and sell the stock (which will forcethe market price down).

3. In conclusion, Financial leverage is a very useful tool if used correctly andunder the right conditions. At times, the value of the firm is enhanced byfinancial leverage.

Measures of financial leverage


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Debt-to-equity

Debt to equity is generally measured as the firm's total liabilities (excludingshareholders' equity) divided by shareholders' equity, where D = liabilities, E =equity and A = total assets:

D / E = (A - E) / E

For different applications of leverage, analysts may include or exclude certain items,such as non-tangible balance sheet items, non-financial liabilities, and similar items,or may adjust the carrying value of other items. It is not uncommon to use onlyfinancial liabilities (long-term and short-term borrowings), thereby excluding, forexample, accounts payable.

Gearing and Du Pont Analysis

Use of the Du Pont Identity requires that leverage be measured in terms of totalassets divided by shareholders' equity (which is further decomposed in thetraditional analysis), and this is sometimes referred to asgearing or simply leverage:

Leverage (gearing) = A / E

The two measures are related. Since the terms used are the same throughout, debt-to-equity is equal to gearing times debt over assets (as the asset term cancels out):

D / E = (A / E) * (D / A)

7.5 COMBINED LEVERAGE

Combined leverage is the product of operating leverage and financial leverage. It is a

proxy for the total risk of a company.

Combined leverage represents an important principle of finance. As it is the product of

financial leverage and operating leverage, companies should be reluctant to increase

financial leverage if the operating leverage is already high. Conversely, companies with

low operating leverage (and therefore operating a stable business) can afford to be

more highly geared.

If both operating and financial leverage allow us to magnify our returns, then wewill get maximum leverage through their combined use in the form of combinedleverage. Operating leverage affects primarily the asset and operating expensestructure of the firm, while financial leverage affects the debt-equity mix. From anincome statement viewpoint, operating leverage determines return from operations,while financial leverage determines how the fruits of labor will be dividedbetween debt holders (in the form of payments of interest and principal on the debt)


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and stockholders (in the form of dividends). Degree of combined leverage (DCL)uses the entire income statement and shows the impact of a change in sales orvolume on bottom-line earnings per share. Degree of operating leverage and degreeof financial leverage are, in effect, being combined.

When financial leverage is combined with operating leverage the effect of a change inoutput (sales) in magnified in the change in earning per share (EPS). Operating

leverage gives us the change in EBIT with a change in sales and financial leverage

gives us the change in EPS with a change in EBIT. We cam then see the change in EPS

for a change in sales (volume of output). The combining both concepts as can be seen

below:

Operating Leverage is:

Change in sales leads to a change inEBIT

Financial Leverage is:

Change inEBITleads to a change in EPS

Therefore, Combined Leverage is:

Change in sales leads to a change in EPS.

Now, we can determine the effect of a change in output (sales) on earnings per share

(EPS). In this way, we can better depict the relative influence of the two types of

leverage for the firm. We can determine and examine the effect of adding financial

leverage on top of operating leverage.

Degree of Combined Leverage =Percent Change in Earnings Per Share

Percent Change in Sales or volume( )

or

Degree of Combined Leverage = Degree of Operating x Degree of Financial

Leverage Leverage

or

Degree of Combined Leverage=


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( )

QuantityatwhichOperating

Leverageiscomputed x pricePerunit Variablecost perunit

QuantityatwhichOperating

LeverageisComputed x Price per unit Variable cost per unitOperatingFixedCosts Intere

( )

Implication:

1. Remember that a firm with high leverage(s) will have large increases in EPS forchanges in sales but will also have large decreases in EPS for decreases in sales(and therefore have high risk).

2. Firms that have lower leverage(s), with have smaller increases in EPS for thesame change in sales and will have smaller decreases in EPS for the samedecrease in sales (and therefore have lower risk).

Since long-term debt interest is a fixed cost, financial leverage tends to take overwhere operating leverage leaves off, further magnifying the effects on earnings pershare of changes in sales levels. In general, high operating leverage shouldaccompany low financial leverage, and vice versa.

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Chapter 07 {Final Energy Financial Management}.Doc