Chapter 4 Analysis of Financial Statements 93rent and the president’s salary) are! xed and will be the same regardless of the
level of sales, while other costs (e.g., manufacturing labor and materials costs)
vary with sales.^9
Notice that everything is the same in the table for the leveraged and unlever-
aged! rms down through operating income—thus, their EBITs are the same in each
state of the economy. However, things differ below operating income. Firm U has
no debt, it pays no interest, its taxable income is the same as its operating income, it
pays a 40% state and federal tax rate, and its net income ranges from $27 under
TTaabbl el e 4 4 - 1. 1 Effects of Financial Leverage on Stockholder ReturnsSTATE OF THE ECONOMY
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 0.0 0.0 0.0
Earnings before taxes (EBT) $ 45.0 $ 15.0 $ 0.0
Taxes (Rate = 40%) 18.0 6.0 0.0
Net income (NI) $ 27.0 $ 9.0 $ 0.0
ROEU 27.0% 9.0% 0.0%
FIRM L !LEVERAGED "SOME DEBT#$
Current assets $ 50 Debt $ 50
Fixed assets 50 Common equity 50
Total assets $100 Total liabilities and equity $100STATE OF THE ECONOMY
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate! 10%) 5.0 5.0 5.0
Earnings before taxes (EBT) $ 40.0 $ 10.0 "$ 5.0
Taxes (Rate! 40%) 16.0 4.0 0.0
Net income (NI) $ 24.0 $ 6.0 "$ 5.0
ROEL 48.0% 12.0% "10.0%
(^9) The! nancial statements do not show the breakdown between! xed and variable operating costs, but
companies can and do make this breakdown for internal purposes. Of course, the distinction is not always clear
because what’s a! xed cost in the very short run can become a variable cost over a longer time horizon. It’s
interesting to note that companies are moving toward making more of their costs variable, using such
techniques as increasing bonuses rather than base salaries, switching to pro! t-sharing plans rather than! xed
pension plans, and outsourcing various operations.
FIRM U !UNLEVERAGED "NO DEBT#$
Current assets $ 50 Debt $ 0
Fixed assets 50 Common equity 100
Total assets $100 Total liabilities and equity $100