© 2000 John Petroff

2)- Effect of combination of operating and financial leverage

To demonstrate the effect of the combination of operating leverage with financial leverage, let us start with the case of modest operating leverage and financial leverage. We continue to use the data for Company X. Graph G-11.1 shows the pattern of earnings per share with 20% debt. The values are extracted from Table T-11.1 through Table T-11.4.

Next, let us add some operating leverage that will reduce unit cost and raise fixed costs. Fixed costs increase from 16,500 to 26,500. The data for the new EPS values is taken from Table T-11.9 through Table T-11.12. Graph G-11.2 shows the effect of operating leverage which is similar to what was presented in the previous chapter.

The effect of operating leverage is the usual increase in profit margin shown by the slope of EPS line, but also an increased break-even point. Next, financial leverage is increase by raising the proportion of debt from 20% to 40%. The data for this third set of numbers also comes from Table T-11.9 through Table T-11.12. Graph G-11.3 shows the additional rise in profit margin but the break-even point is also much higher.

Financial leverage clearly adds to profitability when combined with operating leverage. The potential for loss is also increased. A complete summary of a range of combinations of operating and financial leverage levels is presented in Table T-11.13 below.

Graph G-11.3 shows the pattern of EPS for different levels of financial leverage with fixed costs at 16,500, i.e. a low level of operating leverage.

Graph G-11.4 shows the pattern of EPS for different levels of financial leverage with fixed costs at 26,500, i.e. a high level of operating leverage.

Each time financial leverage goes up so does the break-even point; this increased output is necessary to generate the needed contribution margin to cover the interest expense. This is not surprising because the goal of automation is to achieve a large output, and the learning curve implies that the output must be sold. The consequence is that more customers must be conquered from the competition. This is clearly not an easy task. We just saw in the previous section that financial leverage results in financial risk embodied by an increased variability of earnings per share and a greater potential for default. Initially, financial leverage had nothing to do with commercial risk. But, to the extent that the additional debt is used to increase output by using greater fixed costs (which is a typical usage of debt for automation), financial leverage often also increases commercial risk.

Furthermore, to gain the additional sales and to dispose of the expanded and cheaper output from automation, the most common strategy is to lower price. Lowering price reduces the unit contribution margin and pushes the break-even point further up. Both of which make achieving the needed earnings level to pay fixed charges all the more difficult. The major benefit of financial leverage is preserved: earnings per share are higher compared to the alternative of financing automation and sales expansion with equity. But the volatility of stock price and potential for default are both increased because of the additional commercial risk.

See review questions Q-11D2.1 and Q-11D2.2.

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Last modified: Jun/01/01

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