Principles of Managerial Finance

(Dana P.) #1
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
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