Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

Cost Structure and Operating Leverage

Several other factors affect betas, which in turn affect project discount rates. One of the most important

factors is a company’s cost structure – specifically, its mix of fixed and variable costs. The greater the

importance of fixed costs in a company’s overall cost structure, the more volatile will be its cash flows and

the higher will be its share beta (all other factors held constant). Operating leverage measures the tendency

of operating cash flow volatility to increase with fixed operating costs. Mathematically, the definition of

operating leverage can be expressed as

Eq. 11.2^ =

∆











∆











EBIT

EBIT

Operatingleverage

sales

sales

where EBIT is earnings before interest and taxes (see Chapter 2) and the symbol Δ (Greek upper-

case delta) denotes ‘change in’. Operating leverage equals the percentage change in earnings before

interest and taxes divided by the percentage change in sales. In economics, this is known as a measure

of the elasticity of a variable: it tells us by what percentage the EBIT may change for a given percentage

change of sales. When a small percentage increase (decrease) in sales leads to a large percentage increase

(decrease) in EBIT, the company has high operating leverage. The connection between operating leverage

and costs is easy to see in the next example.

example

Austral Carbonlite uses robotic technology to paint its

finished bicycle frames, whereas its main competitor,

US-based Fiberspeed Corp., offers customised, hand-

painted finishes. Robots represent a significant fixed

cost for Carbonlite, but robots help to keep variable

costs low. Fiberspeed incurs very low fixed costs, but

it has high variable costs because of the time required

to paint frames by hand. Both companies sell their

frames at an average price of $1,000 apiece. Last year

each company made a profit (EBIT) of $1 million on

sales of 10,000 bicycle frames, as shown in Table 11.1.

Suppose that next year, both companies experience a

10% increase in sales volume to 11,000 frames, holding

constant all the other figures. Carbonlite’s fixed costs

do not change, and its EBIT will increase by $600

($1,000 price – $400 variable costs) per additional

frame sold. Thus, Carbonlite’s EBIT will increase

60% from $1 million to $1.6 million, so its operating

leverage is 6.0 (60% ÷ 10%). Fiberspeed’s EBIT grows

from $1 million to $1.3 million, an increase of just 30%,

so its operating leverage is 3.0 (30% ÷ 10%).

Because Carbonlite has higher fixed costs

and lower variable costs, its profits increase more

rapidly in response to a given increase in sales than

do Fiberspeed’s profits. In short, Carbonlite has

more operating leverage. Figure 11.1 shows this

graphically. The figure shows two lines, one tracing

out the relationship between sales growth (from the

base of 10,000 frames per year) and EBIT growth

(from the $1 million EBIT base) for Carbonlite, the

other illustrating the same linkage for Fiberspeed.^1

Because of its greater operating leverage, the line

for Carbonlite is much steeper than the one for

Fiberspeed. Even though Carbonlite and Fiberspeed

compete in the same industry, they may well use

different discount rates in their capital budgeting

analysis, because operating leverage increases the

risk of Carbonlite’s cash flows relative to Fiberspeed’s.

operating leverage
Measures the tendency of
operating cash flow volatility
to increase with fixed
operating costs

1 These comparisons are based on a reference point of 10,000 frames per year sold for $1,000 per frame and an EBIT of $1 million. All changes

described and shown in Figure 11.2 assume these points of reference in each case. Clearly, the sensitivity of these values to change will

vary depending on the point of reference utilised.