Why are the concepts of leverage and break-even important for managers to understand in order to achieve the goals of Saudi Vision 2030? Provide an example of how these concepts could be applied to a business with which you are familiar.
Search the library or the Internet for an academic or industry-related article. Select an article that relates to these concepts in the context of doing business in Saudi Arabia.
For your discussion post, your first step is to summarize the article in two paragraphs, describing what you think are the most important points made by the authors (remember to use citations where appropriate). For the second step, include the reference listing with a hyperlink to the article.
FIN500
Principles of
Finance
Module 7 Live Session
1
2
Module 7 Learning Outcomes
? Understand
risk and its measurement.
? Understand expected return and its
measurement.
? Understand the effects of leverage.
? Comprehend and calculate break-even
sales levels.
? Review for Mid-Term Exam
Chapter 6
The Meaning and
Measurement of Risk
and Return
4
Holding-Period Return
Historical or holding-period or realized rate of return
Holding-period return = payoff during the
“holding” period. Holding period could be
any unit of time such as one day, few weeks
or few years.
5
Holding-Period Return
? You
bought 1 share of HPD for $19.70 in
May 2011 and sold it for $32.32 in May
2012. The company paid dividends of 8
cents every quarter during the last two
years.
? Holding-period
dollar gain, DG
= 32.32 + 0.08*4 – 19.70
= $12.94
6
Holding-Period Rate of Return
Holding-period rate of return
= 12.94/19.70
= 0.6568 or 65.68%
7
Expected Return
Expected Cash Flows and Expected Rate
of Return
? The expected benefits or returns an
investment generates come in the form of
cash flows.
? Cash flows are used to measure returns
(not accounting profits).
8
Expected Return
? The
expected cash flow is the weighted
average of the possible cash flows
outcomes such that the weights are the
probabilities of the occurrence of the
various states of the economy.
? Expected Cash flow (X) = ?Pbi*CFi
?
?
Where Pbi = probabilities of outcome i
CFi = cash flows in outcome i
9
Table 6-1
10
Expected Cash Flow Equation
11
Expected Cash Flow
? Expected
Cash flow = ?Pbi*CFi
= (0.2*1000) + (.3*1200) + (0.5*1400)
= $1,260 on $1,000 investment
12
Expected Rate of Return
? Expected
Return (%) = ?Pbi*ri
where
Pi = probabilities of outcome i
ki = expected % return in outcome I
= 0.2(10%) + 0.3(12%) + 0.5(14%)
= 12.6%
13
Return
Given:
Investment A
100,000
12%
Investment B
300,000
15%
Investment C
600,000
17%
What is expected
return of portfolio?
Solution:
1. Add up investments
2. Find % of each investment of total
3. Multiply % x Return
4. Add up totals
% of
Investment
Return
Total
Investment A
100,000
10%
12%
1.200%
Investment B
300,000
30%
15%
4.500%
Investment C
600,000
60%
17%
10.200%
TOTAL
1,000,000
15.900%
14
RISK DEFINED AND MEASURED
15
Risk Defined
? Risk
refers to potential variability in future
cash flows.
? The wider the range of possible future
events that can occur, the greater the
risk.
? Thus, the returns on common stock are
more risky than returns from investing in a
savings account in a bank.
16
Risk Measured
Consider two investment options:
1.
2.
Invest in Treasury bond that offers a 2%
annual return.
Invest in stock of a local publishing
company with an expected return of 14%
based on the payoffs (given on next
slide).
17
Probability of Payoffs
Probability
Treasury Bill
100%
Stock
10%
20%
40%
20%
10%
Rate of Return
2%
-10%
5%
15%
25%
30%
18
Expected Rate of Return
? Treasury
bond = 1*2% =2%
? Stock
= (0.1*-10) + (0.2*5%) + (0.4*15%) +(0.2*25%) + (0.1*30%)
= 14%
19
Figure 6-1
20
Figure 6-1
Treasury Bond versus Stock
? We
observe from Figure 6-1 that the stock
of the publishing company is more risky
but it also offers the potential of a higher
payoff.
21
Standard Deviation (S.D.)
? Standard
deviation (S.D.) is one way to
measure risk. It measures the volatility or
riskiness of portfolio returns.
? S.D.
= square root of the weighted average
squared deviation of each possible return
from the expected return.
? If Stock A has an expected return of 12% and
a standard deviation of 5%, its returns will
normally be between 7% and 17%.
22
RISK AND DIVERSIFICATION
23
Portfolio
? Portfolio
assets.
refers to combining several
? Examples
?
?
of portfolio:
Investing in multiple financial assets
(stocks – $6000, bonds – $3000, T-bills –
$1000)
Investing in multiple items from a single
market (example: investing in 30 different
stocks)
24
Risk and Diversification
?
Total risk of portfolio is due to two types of risk:
?
?
?
?
Systematic (or market risk) is risk that affects all firms
(ex.: tax rate changes, war)
Unsystematic (or company-unique risk) is risk that
affects only a specific firm (ex.: labor strikes, CEO
change)
Only unsystematic risk can be reduced or
eliminated through effective diversification.
(Figure 6-3)
All risk is not equal because some risk can be
diversified away and some cannot
25
Total Risk & Unsystematic Risk
Decline as Securities Are Added
26
Correlation and Risk Reduction
?
The main motive for holding multiple assets or
creating a portfolio of stocks (called
diversification) is to reduce the overall risk
exposure. The degree of reduction depends
on the correlation among the assets.
?
?
If two stocks are perfectly positively correlated,
diversification has no effect on risk.
If two stocks are perfectly negatively correlated,
the portfolio is perfectly diversified.
27
Interpreting Beta
?
Beta is the risk that remains for a company
even after we have diversified our portfolio.
?
?
?
?
A stock with a Beta of 0 has no systematic risk
A stock with a Beta of 1 has systematic risk equal
to the “typical” stock in the marketplace
A stock with a Beta exceeding 1 has systematic
risk greater than the “typical” stock
Most stocks have betas between 0.60 and
1.60. Note, the value of beta is highly
dependent on the methodology and data
used.
28
Portfolio Beta
? Portfolio
beta indicates the percentage
change on average of the portfolio for
every
1 percent change in the general market.
?portfolio = ? wj*?j
Where wj = % invested in stock j
?i = Beta of stock j
29
Risk and Diversification
Demonstrated
? The
market rewards diversification.
? Through
effective diversification, we can
lower risk without sacrificing expected
returns and we can increase expected
returns without having to assume more
risk.
30
Asset Allocation
? Asset
allocation refers to diversifying
among different kinds of asset types (such
as treasury bills, corporate bonds,
common stocks).
? Asset allocation decision has to be made
today – the payoff in the future will
depend on the mix chosen before, which
cannot be changed. Hence asset
allocation decision is considered the “most
important decision” while managing an
investment portfolio.
31
Historical Returns in the
U.S. Market: 1926–2000
? Treasury
Bills
? Government Bonds
? Corporate Bonds
? Common Stocks
(S&P 500)
? Small Company Stocks
3.9%
5.6%
6.0%
13.0%
17.3%
32
THE INVESTOR’S
REQUIRED
RATE OF RETURN
33
The Investor’s
Required Rate of Return
? Investor’s
required rate of return is the
minimum rate of return necessary to
attract an investor to purchase or hold a
security.
? This definition considers the opportunity
cost of funds, i.e., the foregone return on
the next best investment.
34
The Investor’s Required
Rate of Return
35
Risk-Free Rate
? This
is the required rate of return or
discount rate for risk-free investments.
? Risk-free
rate is typically measured by the
U.S. Treasury bill rate.
36
Risk Premium
? The
risk premium is the additional return
we must expect to receive for assuming
risk.
? As
the level of risk increases, we will
demand additional expected returns.
37
Capital Asset Pricing Model
(CAPM)
? CAPM
equation equates the expected
rate of return on a stock to the risk-free
rate plus a risk premium for the systematic
risk.
? CAPM
provides for an intuitive approach
for thinking about the return that an
investor should require on an investment,
given the asset’s systematic or market risk.
38
Measuring the Required
Rate of Return
39
Capital Asset Pricing Model
? If
the required rate of return for the market
portfolio rm is 12%, and the rf is 5%, the risk
premium for the market would be 7%.
? This 7% risk premium would apply to any
security having systematic
(nondiversifiable) risk equivalent to the
general market, or beta of 1.
? In the same market, a security with beta
of 2 would provide a risk premium of 14%.
40
CAPM
CAPM suggests that beta is a factor in
determining the required returns.
41
CAPM Example
Market risk = 12%
Risk-free rate = 5%
Required return = 5% + beta * (12% – 5%)
If beta = 0
If beta = 1
If beta = 2
Required return = 5%
Required return = 12%
Required return = 19%
5% + (2x (12%-5%) = 19%
Chapter 12
Determining the
Financing Mix
43
UNDERSTANDING THE DIFFERENCE
BETWEEN BUSINESS AND FINANCIAL RISK
44
Risk
? Risk
is variability associated with expected
revenue or income streams. Such
variability may arise due to:
?
?
?
Choice of business line (business risk)
Choice of an operating cost structure
(operating risk)
Choice of a capital structure (financial risk)
45
Business Risk
? Business
risk is the variation in the firm’s expected
earnings attributable to the industry in which the firm
operates (Outside Risks). There are four determinants
of business risk:
?
?
?
?
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
46
Operating Risk
? Operating
risk is the variation in the firm’s
operating earnings that results from firm’s
cost structure (mix of fixed and variable
operating costs).
? Earnings of firms with higher proportion of
fixed operating costs are more vulnerable
to change in revenues.
47
Financial Risk
? Financial
risk is the variation in earnings as
a result of firm’s financing mix or
proportion of financing that requires a
fixed return.
48
Break-Even Analysis
? Break-even
analysis is used to determine the
break-even quantity of a firm’s output by
examining the relationships among the firm’s
cost structure, volume of output, and profit.
? Break-even may be calculated in units or
sales dollars.
? Break-even point indicates the point of sales
or units at which EBIT is equal to zero (i.e
covers all operating costs).
49
Break-Even Analysis
Use of break-even model enables the
financial manager to
? determine the quantity of output that must
be sold to cover all operating
costs, as distinct from financial costs.
? calculate the EBIT that will be
achieved at various output levels.
50
Essential Elements of
the Break-Even Model
? Break-even
analysis requires information
on the following:
?
?
?
?
Fixed Costs
Variable Costs
Total Revenue
Total Volume
51
Essential Elements of
the Break-Even Model
? Break-even
analysis requires classification of costs into
two categories:
?
?
Fixed costs or indirect costs
Variable costs or direct costs
? Since
all costs are variable in the long run, break-even
analysis is a short-run concept.
52
Fixed or Indirect Costs
? These
costs do not vary in total amount as sales
volume or the quantity of output changes.
?
?
?
As production volume increases, fixed costs per unit of
product falls, as fixed costs are spread over a larger and
larger quantity of output (but total remains the same).
Fixed costs vary per unit but remain fixed in total.
The total fixed costs are generally fixed for a specific
range of output.
53
Fixed Costs Examples
1.
2.
3.
4.
5.
6.
Administrative salaries
Depreciation
Insurance
Lump sums spent on intermittent
advertising programs
Property taxes
Rent
54
Variable or Direct Costs
? Variable
costs vary as output changes.
Thus if production is increased by 5%, total
variable costs will also increase
by 5%.
55
Variable Costs Examples
1.
2.
3.
4.
5.
6.
Direct labor
Direct materials
Energy costs (fuel, electricity, natural gas)
associated with the production
Freight costs
Packaging
Sales commissions
56
The Behavior of Costs
57
Revenue
? Total
revenue is the total sales dollars.
? Total revenue = P ? Q
P = selling price per unit
Q = quantity sold
58
Volume
? The
volume of output refers to the
firm’s level of operations and may be
indicated either as a unit quantity or as
sales dollars.
59
Break-Even Point (BEP)
? BEP
= Point at which EBIT equals zero
? EBIT = (Sales price per unit) (units sold)
– [(variable cost per unit) (units sold)
+ (total fixed cost)]
60
Break-Even Point (BEP)
61
Example
? Selling
price = $12 per unit
Variable cost = $6 per unit
Fixed costs = $120,000
? BEP (units)
= $120,000/ ($12 – $6)
= $120,000/$6
= 20,000 units
? If the firm sells 20,000 units, EBIT will be equal to zero
dollars.
62
Example
?
? At
sales of $240,000, EBIT will be equal to
zero dollars.
63
Example
? Selling
price = $10 per unit
? Variable cost = $6 per unit
? Fixed cost = $100,000
64
Operating Leverage
? Operating
leverage measures the
sensitivity of the firm’s EBIT to fluctuation in
sales, when a firm has fixed operating
costs.
? If
the firm has no fixed operating costs,
EBIT will change in proportion to the
change in sales.
65
Operating Leverage
?
? Thus
% change in EBIT
= OL ? % change in sales
Where :
% change in EBIT = EBITt1 – EBITt / EBITt
% change in sales = Salest1 – Salest / Salest
66
Operating Leverage
? Example
: If a company has an operating leverage
(OL) of 6, then what is the change in EBIT if sales
increase by 5%?
% change in EBIT = OL ? % change in sales
= 5% ? 6 = 30%
? Thus, if the firm increases sales by 5%, EBIT will increase
by 30%
67
Operating Leverage
? Operating
leverage is present when
% change in EBIT / % change in sales is
> 1.00
? The
greater the firm’s degree of operating
leverage, the more the profits will vary in
response to change in sales.
68
Financial Leverage
? Financial
leverage means financing a
portion of the firm’s assets with securities
bearing a fixed (limited) rate of return in
hopes of increasing the return to the
common stockholders.
? Thus the decision to use preferred stock or
debt exposes the common stockholders
to financial risk.
? Variability of EBIT is magnified by the firm’s
use of financial leverage.
69
Midterm Exam Review
Chapters 1 – 6 & Chapter 12
70
5 Basic Principles of Finance
? Cash
flow is what matters
? Money has a time value
? Risk requires reward
? Market prices are generally right
? Conflicts of interest cause agency
problems
71
Applying Finance Principles
? Shareholder
wealth maximization means
maximizing price of existing common stock
? To reduce agency problems, managers
should have compensation that includes an
option to buy the company’s stock
? Investors want a return that satisfies a return
for delaying consumption and an additional
return for taking risk
72
When evaluating projects
? Time
value of money concept is used to
bring future benefits and costs of a
project, measured by its cash flows, back
to the present
? Use After-tax cash flows for the company
as a whole
? Select projects where present value of
cash inflows exceeds present value of
project’s cash outflows
73
Financial statement concepts
? Income
?
statement format is:
Sales – Expenses = Profit
? Longer
format:
Sales
– Cost of Goods Sold
= Gross Profit
– Operating Expenses
= Operating Income (Earnings Before Interest & Tax (EBIT))
– Interest Expense
= Earnings before tax
– Income tax
= Net Income
74
Income statement
Balance Sheet
75
Purchase of treasury stock reduces equity
Market Value Added = Market price of stock and amount invested in the firm
76
Sources of Financing
? Debt
& equity
? Stock price might decrease for companies
with high levels of debt compared to peers
because of riskiness
? Common stockholders are the true owners of
the firm
? Optimal capital structure is the funds mix that
will minimize the firm’s composite cost of
capital
77
Financial ratios
? Return
on invested capital must exceed
investors’ required rate of return to create
shareholder value. (i.e. earning 9% but
investors require 11%)
78
Liquidity ratios
BE ABLE TO CALCULATE
?
?
?
?
?
?
?
?
?
Inventory turnover
Current Ratio
Acid-test ratio (Quick Ratio)
Debt Ratio
Operating return on assets
Gross profit margin
Accounts receivable turnover
Inventory turnover
Total asset turnover
79
Time value of money
calculations
?
Know how to calculate using financial
calculator:
?
?
?
?
?
?
?
?
Future value of lump sum
Present value of a lump sum
Present value of annuity
Present value of annuity due
Future value of annuity due
Annual interest rate
Annual payment to pay off debt
Annual payment received
Annuity due means payments made at beginning of year
80
Return
Given:
Investment A
100,000
12%
Investment B
300,000
15%
Investment C
600,000
17%
What is expected
return of portfolio?
Solution:
1. Add up investments
2. Find % of each investment of total
3. Multiply % x Return
4. Add up totals
% of
Investment
Return
Total
Investment A
100,000
10%
12%
1.200%
Investment B
300,000
30%
15%
4.500%
Investment C
600,000
60%
17%
10.200%
TOTAL
1,000,000
15.900%
81
Risk
? Market
risk – changes in general economy (i.e.
tax rates)
? Asset unique risk = asset unique risk
? Systematic risk = market risk = undiversifiable
risk
? Beta is statistical measure of the relationship
between an investment’s returns and market
value
? Risk-averse investors choose companies from
different industries for their portfolios because
less correlation than if all companies from
same industry
82
BUSINESS Risk – 4 determinants
? Stability
of the domestic economy
? Exposure to, and stability of, foreign
economies
? Sensitivity to the business cycle
? Competitive pressures of the firm’s industry
If a firm has a high degree of variability in earnings before
interest and taxes, this is an indicator of business risk.
Determinants tend to come from outside company rather
than company’s assets or production process.
83
Break-even model
?
?
?
?
Enables manager to determine the quantity of
output that must be sold to cover all operating
costs
Operating leverage is associated with using
more fixed costs for production
Calculate break even number of units
Break even point influenced by:
?
?
?
?
Fixed costs
Sales price per unit
Variable costs
Note: Number of units actually sold does NOT
impact breakeven point
84
Annuity and perpetuity
? Explain
what an annuity is and give
examples. (mortgage, lease payments,
car loan payments)
? What is the difference between an
ordinary annuity and an annuity due?
85
Be prepared
? Explain
what is meant by asset allocation
? Why is examination of only the balance sheet
not adequate to evaluate financial condition
of firm?
? What are two perspectives that can be taken
in performing ratio analysis?
? What is the time value of money and why is it
important?
? What is the relationship between
compounding and discounting cash flows?
86
Be Prepared
? What
factors influence business risk?
? Why is there still a return on an investment
that does not have risk?
? What are the 5 principles that are the
foundation of finance?
? What effect will diversifying a portfolio
have on an investor’s returns and level of
risk?
87
Your Questions
? Need
clarification? Ask your questions!
Discussion (1)
The break-even tool is critical for decision-makers to determine the amount to be sold to
cover all operation costs and to calculate the earnings before interest and taxes that can be
met at different output levels (Keown, Martin, and Petty, 2017). This is a crucial tool to
compare the output levels with sales, for example, a company can know that its output levels
are supported by healthy sales so it can profit and maintain its position in the market. One of
the suppliers of a pharma company in KSA gives more discounts after meeting the breakeven quantity, the supplier will have a competitive advantage by utilizing this tool knowing
the time all expenses are met. Break-Even Analysis can be applied to many other aspects in
life, Safieddine, and Nakhoul (2016) state that the break-even point for carbon footprint can
show the path to new technologies if they are better to substitute current items.
According to Keown, Martin, and Petty (2017) the operating leverage results from
fixed operating costs. This means that high operation leverage can have a strong effect on
earnings before interest and taxes. On the other hand, if management control financial
leverage the can save and distribute cost more flexible.
One of the goals of the Saudi 2030 vision is to have an economy that is not dependent
on oil. Companies need to invest in sectors where they can gain a competitive advantage.
This will allow Saudi companies to maintain their position in the global market and continue
to grow. By understanding leverage and break-even concepts managers can make better
decisions related to the business, and how the business interacts with the market (Vision
2030, 2016).
References
Keown, A. J., Martin, J. D., & Petty, J. W. (2017). Foundations of finance: The logic and
practice of financial management (9th ed.). Upper Saddle River, NJ: Prentice Hall.
Safieddine, F., & Nakhoul, I. (2016). Carbon break even analysis: Environmental impact of
tablets in higher education. Carbon, 7(5). Retrieved from
https://pdfs.semanticscholar.org/c798/1888011e3fde763da0b88ffaf275f358119e.pdf
Vision 2030. (2016, April 25). Retrieved from https://vision2030.gov.sa/en
Discussion (2)
Concepts of Leverage and Break-Even
Break-even
Kampf, Majercák, and Svagr (2016) notes that the break-even is the point where
the number of sales either in units or quantities or revenues covers or equals to the
total cost. It is made up of fixed and variable costs in a firm. At the break-even,
The point of the profits is always zero. For instance, in business-like setting up a
chicken house for the sake of poultry production, there are various costs of inputs.
When the farm begins production, the point at which the cost of input will equal
the output cost is referred to as the break-even point.
Leverage
The concept of leverage is one that is used mainly when referring to financial
instruments or borrowed capital with the objective of increasing the potential
return of the investment. Leverage at times may be used to imply to the amount of
debt that can be used when financing assets. When a shopkeeper wants to increase
the stock and goes for more stock, they are said to be financially leveraging on the
business.
This the paper analyses the two concepts and establishes their significance towards
achievement of Saudi Vision 2030.
Significance of Break-Even and Leveraging
The concept of break-even is important to the economy in many ways. First, the
concept assists in budgeting and setting targets. Given that the economists are
aware of the point at which they can break even, they can comfortably put up a
budget that can cover all the costs (Keown et al., 2017). Through break-even, it is
possible to create some form of realistic targets for the businesses and different
sectors of the economy. Each part of the economy will have a set target.
Determination of Margin of Safety
The margin of safety for any economy can be calculated by doing away with the
sales from the break-even point and then dividing with the selling price (Barletta,
Despeisse & Johansson, 2018). Through break-even, the economists are in a
position to tell if the projects in place for Vision 2030 are going to be realized
within the margin of safety. They can help understand the trend especially during
the recession or an economic downturn where sales always seem to be on the
downward trend. Hence, for each sector of the Saudi economy, the break-even will
help to tell the minimum sales that will be needed to ensure profit realization.
Through knowing the margin of safety for a given product or service, the managers
end up making the best business decisions that will be in line with the
achievements and goals set for Vision 2030.
Cost Control and Monitoring
Break-even is instrumental in cost control and monitoring. Given that managers
are aware of the fixed and variable costs which impact the profit level of the
companies, they can monitor them and find out how best they affect the changes to
costs. The monitoring happens through break-even analysis. Hence, the managers
of different projects within the economy will be in a position to tell the points at
which the break-even will occur.
Devising Pricing Strategy
Changes the selling price can impact so much on the break-even point and the
extent to which businesses leverage on their finances. In case there is an increase in
the selling price, the number of items that are sold to realize the break-even end up
reducing (Keown et al., 2017). In case the selling price reduces, the firm has to sell
more for it to break-even. Through the analysis, the managers can comfortably opt
to know if they should modify the sale price and come up with a new pricing
strategy all the same. Hence, through the break-even analysis and leveraging,
several businesses will be in a position to arrive at fast financial decisions and
hence make important business decisions.
Conclusion
Break-even and leverage is important concepts when achieving Vision 2030. The
two concepts help so much in the assessment of the viability of projects required to
realize Vision 2030. Key examples have been given to support the concepts and
explanation on their significance to the economy of Saudi in the realization of
Vision 2030 explained.
References
Barletta, I., Despeisse, M., & Johansson, B. (2018). The proposal of an
environmental breakeven point as assessment method of product-service systems
for circular economy. Procedia CIRP,72,720-725.Retrieved
from https://research.chalmers.se/publication/504006/file/504006_Fulltext.pdf
Kampf, R., Majercák, P., & Svagr, P. (2016). Application of Break-Even Point
Analysis/Primjena Break-Even Point analize. Nase More, 63(3), 126.
Keown, A. J., Martin, J. D., Petty, J. W., & Scott, D. F. (2017). Foundations of
Finance: The Logic and Practice of Financial Management (9? ed.).

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