OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK

<< BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory >>

Financial Management MGT201

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

EBIT= (PQ) (VQ) F = 0.

From this by solving equation we can derive

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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

= <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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Financial Management MGT201

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: 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

Interest (10% of 500)

EBT

300

250

Tax (30% of EBIT)

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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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

180

420

42%

Firm with

300

210

21%

no debt or 100%

3.5%

equity

Levered firm

600

550

165

385

77%

with debt

300

250

175

35%

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

EBIT (Rs)

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

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

<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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