Chapter Concepts: * Leverage represents the use of fixed cost items to magnify the firm's results.

* Breakeven analysis allows the firm to determine the magnitude of operations necessary to avoid loss. * Operating leverage indicates the extent fixed assets (plant & equipment) are utilized by the firm. * Financial leverage shows how much debt the firm employs in its capital structure. *Combined leverage takes into account both the use of fixed assets and debt. *By increasing leverage, the firm increases its profit potential, but also its risk of failure. Leverage in a Business: The use of fixed charge obligations with the intent of magnifying the potential return to the firm. A. Fixed operating costs: Those operating costs that remain relatively constant regardless of the volume of operations such as rent, depreciation, property taxes, and executive salaries. B. Fixed financial costs: The interest costs arising from debt financing that must be paid regardless of the level of sales or profits. Operating Leverage: A. Break-even analysis: A numerical and graphical technique used to determine at what point the firm will break even. 1. Break-even point: the unit sales where total revenue = total costs. 2. Contribution Margin per unit is sales price (per unit) minus variable costs per unit. 3. Formula for break-even point in units: (See formula 5-1). B. The risk factor in using financial leverage depends on the firms operations relative to its breakeven point and it operating leverage. Managements willingness to take risk is also a function of its view of future economic conditions C. Cash break-even analysis: 1. Deducting non-cash fixed expenses such as depreciation in the break-even analysis enables one to determine the break-even point on a cash basis. 2. Although cash break-even analysis provides additional insight, the emphasis in the chapter is on the more traditional accounting-data related break-even analysis. D. Operating leverage: A reflection of the extent fixed assets and fixed costs are utilized in the business firm. The employment of operating leverage causes operating profit to be more sensitive to changes in sales. 1. The use of operating leverage increases the potential return but it also increases potential losses.

2. The amount of leverage employed depends on anticipated economic conditions, nature of the business (cyclical or noncyclical), and the risk aversion of management. 3. The sensitivity of a firm's operating profit to a change in sales as a result of the employment of operating leverage is reflected in its degree of operating leverage. 4. Degree of operating leverage (DOL) is defined as the ratio of percentage change in operating income in response to percentage change in volume. DOL = % change in operating income devided by % change in volume 5.The DOL may also be computed using the formula 5-3 in the text where: Q = quantity at which DOL is computed P = price per unit VC = variable cost per unit FC = fixed costs CM = Contribution Margin EBIT = Earnings Before Interest and Taxes 6. DOL and other measures of leverage always apply to the starting point for the range used in the computation. 7. The normal assumption in doing break-even analysis is that a linear function exists for revenue and costs as volume changes. This is probably reasonable over a reasonable range. However, for more extreme levels of operations, there may be revenue weakness and cost overruns. Some non-linearity may exist. Financial Leverage: A measure of the amount of debt used in the capital structure of the firm. A. Two firms may have the same operating income but greatly different net incomes due to the magnification effect of financial leverage. The higher the financial leverage, the greater the profits or losses at high or low levels of operating profit, respectively. C. Financial leverage is beneficial only if the firm can employ the borrowed funds to earn a higher rate of return than the interest rate on the borrowed amount. The extent of a firm's use of financial leverage may be measured by computing its degree of financial leverage (DFL). The DFL is the ratio of the percentage change in net income (or earnings per share) in response to a percentage change in EBIT. D. The DFL may also be computed utilizing the following formula: percent change in EPS devided by percent change in EBIT. E. The DFL is associated with a specific level of EBIT and changes as EBIT changes. F. The purpose of employing financial leverage is to increase return to the owners but its use also increases their risk. G. The use of financial leverage is not unlimited.

1. Interest rates that a firm must pay for debt-financing rise as it becomes more highly leveraged. 2. As the risk to the stockholders increases with leverage, their required rate of return increases and stock prices may decline. Combining Operating and Financial Leverage: A. Combining operating and financial leverage provides maximum magnification of returns-it also magnifies the risk. B. The combined leverage effect can be illustrated through the income statement. C. The degree of combined leverage (DCL) is a measure of the effect on net income as a result of a change in sales. The DCL is computed similar to DOL or DFL.