Capital Structure Management: Understanding Operating and Financial Leverage, Slides of Fundamentals of E-Commerce

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Contemporary Financial

Management

Capital Structure Management

Introduction

This chapter focuses on analytic tools to assistmanagers in making capital structuredecisions that maximize shareholder wealth.

It also develops techniques for measuringoperating and financial leverage.

Operating Leverage

The change in Earning Before Interest andTaxes (EBIT), given a change in sales revenue.

The Degree of Operating Leverage (DOL) is thepercentage change in EBIT, given a 1% changein sales revenue

Financial Leverage

The change in Earnings Per Share (EPS), givena change in EBIT

The Degree of Financial Leverage (DFL) is the% change in EPS, given a 1% change in EBIT

Example: Fixed Versus Variable

Cost

A company installs underground lawnsprinklers. The company must choosebetween laying pipe manually or buying amachine to lay the pipe .

If pipe laid manually and sales volume decreases,the company can lay off workers to reduce itscosts. - If pipe laid by machine, company has a fixed costof ownership that occurs whether the machineoperates or not. If sales volume increases, thefixed cost of machine ownership remains the same, whereas the variable cost of labour will

Cost versus Output

Output Cost Semi-variable Costs Fixed Costs

Degree of Operating Leverage

Measured as the percentage change inearnings before interest and taxes (EBIT)resulting from a one percent change in sales Sales - Variable Costs DOL at X = EBIT EBIT = Sales - Variable Costs - Fixed Co sts ∆ ∆     ÷         EBIT Sales DOL at X = EBIT Sales

Operating Leverage

Must measure the Degree of OperatingLeverage (DOL) at a given level of sales, X

The DOL rises as EBIT approaches 0 - The DOL rises as variable costs are replacedwith fixed costs - When a variable cost is replaced with a fixedcost, the breakeven level of sales will increase - When a variable cost is replaced with a fixedcost, both profits and losses grow faster assales rise and fall on either side of the breakeven point

Concept of DOL

Revenue TotalCost Fixed Cost Quantity Dollars Breakeven Quantity High Fixed Costs with Low Variable Costs High Breakeven; Profits/Losses Increase Quickly Profit Variable Cost