Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 515

In Practice

Adobe Systems, the second
largest PC software company in
the United States, dominates the
graphic design, imaging, dynamic
media, and authoring-tool soft-
ware markets. Web site designers
prefer its Photoshop and Illustrator
software applications, and
Adobe’s Acrobat software has
become a standard for sharing
documents online.
Despite a sales slowdown in
2001, the company continued to
meet its earnings targets. Its abil-
ity to manage discretionary
expenses helped to keep its bot-
tom line strong. As a software
company, it has an additional
advantage:operating leverage,the
use of fixed operating costs to
magnify the effect of changes in
sales on earnings before interest
and taxes (EBIT).
Adobe and its peers in the
software industry incur the bulk of
their costs early in a product’s life
cycle, in the research and devel-
opment and initial marketing
stages. The up-front development
costs are fixed, regardless of how

many copies of a program the

company sells, and subsequent

production costs are practically

zero. The economies of scale are

huge; once a company sells

enough copies to cover its fixed

costs, incremental revenue dollars

go primarily to profit.

The following table demon-

strates the impact of operating

leverage on Adobe Systems in

fiscal years (FYs) 2000 and 2001.

Operating leverage magnified

the increase in EBIT in 2000. Sales

growth of 24.7 percent resulted in

EBIT growth of 56.9 percent. In

2001 a slight dip in sales—just

under 3 percent—became a 7.4

percent drop in EBIT. Because the

company has no long-term debt in

its capital structure, its total lever-

age is derived only from fixed

operating costs. When sales and

EBIT again rise, the company’s

high operating leverage will boost

EBIT growth. (It’s important to

remember that this example repre-

sents only 2 years and that

Adobe’s degree of operating lever-

age may change in the future.)

Sources:Adapted from Zeke Ashton, “The

Software Advantage,”Motley Fool

(March 31, 2000), downloaded from

http://www.fool.com;James K. Glassman, “Tech

Still Has a Place in Portfolios,”Washington

Post, December 16, 2001, p. H1; Matt

Richey, “EMC’s Operating Leverage,”Mot-

ley Fool(August 14, 2000); Mike Trigg,

“Assessing Adobe’s Valuation,”Motley Fool

(September 10, 2001); and “Operating Lever-

age Helps Adobe,”Motley Fool(March 16,

2001), all downloaded fromwww.fool.com.

FOCUS ONPRACTICE Adobe’s Design for Profitability

FY 1999 FY 2000 FY 2001

Sales revenue (millions) $1,015 $1,266 $1,230

EBIT (millions) $260 $408 $378

(1) % change in sales 24.7 2.9

(2) % change in EBIT 56.9 7.4

DOL [(2)(1)] 2.3 2.6

mission basis. The effects of changes in fixed operating costs on operating lever-

age can best be illustrated by continuing our example.

EXAMPLE Assume that Cheryl’s Posters exchanges a portion of its variable operating costs

for fixed operating costs by eliminating sales commissions and increasing sales

salaries. This exchange results in a reduction in the variable operating cost per

unit from $5 to $4.50 and an increase in the fixed operating costs from $2,500 to

$3,000. Table 12.5 presents an analysis like that in Table 12.4, but using the new

costs. Although the EBIT of $2,500 at the 1,000-unit sales level is the same as

before the shift in operating cost structure, Table 12.5 shows that the firm has

increased its operating leverage by shifting to greater fixed operating costs.

With the substitution of the appropriate values into Equation 12.5, the

degree of operating leverage at the 1,000-unit base level of sales becomes

DOL at 1,000 units2.2

$5,500



$2,500

1,000($10$4.50)



1,000($10$4.50)$3,000