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Leverage in business is derived from the word ‘lever’. A lever is a simple tool
by which a large weight can be moved with a small force.
OPERATING LEVERAGE
Firms with large amounts of fixed operating costs have high break-even points
and high operating leverage. Variable cost in these firms tends to be low and
both the contribution (CM) and unit contribution (UC) margin is high.
Contributi on Margin
Degree of Operating Leverage = Earnings Before Interest and Taxes
or
Degree of Operating Leverage =
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or
Example :
Company A and Company B are competitors in the market for a special machine
part. The cost structure and price details are given below:
Company A Company B
Selling price AED 30 AED 30
Variable cost per unit AED 10 AED 20
Fixed costs AED 60,000 AED 20,000
Answer :
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Company A
Units sold Variable costs Fixed costs Total costs Revenue Operating
Income (loss)
0
2,000
3,000
4,000
5,000
Company B
Units sold Variable costs Fixed costs Total costs Revenue Operating
Income (loss)
0
2,000
3,000
4,000
5,000
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Dubai Women's College BADM300 Financial Management
Implications:
1. A firm with a high break-even point is more risky than one with a low
Break-even point. In periods of increasing sales, operating income (OI or
EBIT) of the leveraged firm tends to increase rapidly. This increase in
OI (EBIT) is the ‘pay-off’ for being more risky. But in periods of
decreasing sales, operating income of the firm tends to decrease
rapidly, that is the risk.
2. Firms with small amounts of fixed operating costs have low break-even
points and are therefore less risky and have low operating leverage.
Variable costs in these firms tend to be high and both the CM and UC is
low. In periods of increasing sales, Operating income (EBIT) for these
firms tends to increase slowly. But in periods of decreasing sales,
Operating income will tend to decrease slowly making the firm less risky.
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Dubai Women's College BADM300 Financial Management
FINANCIAL LEVERAGE
Financial leverage is the extent to which debt (liability) is used in the Capital
Structure (financing) of the firm. Capital Structure refers to the relationship
between assets, debt (liability) and equity. The more debt a firm has relative
to equity the greater the financial leverage (these firms have a higher Debt to
Asset ratios).
Example :
Company A Company B
Debt (10%) 100,000 Debt (10%) 40,000
Sh. Equity (AED 10 par) 40,000 Sh. Equity (AED 10 par) 100,000
(4,000 shares) --------- (10,000 shares) ----------
Total Capital 140,000 Total Capital 140,000
Substantial use of debt will place a great burden on the firm at low levels of
profitability (low EBIT, since interest must be paid). However, it will also help
to magnify (enlarge) increases in earning per share (EPS) as the EBIT or
operating income increases.
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EPS EPS
EPS EPS
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Implications
1. Financial leverage can be very useful to a firm if properly used under the
right conditions. For firms in industries that have a degree of stability
and/or show growth, the use of debt is recommended because of the
positive aspects of financial leverage.
BUT...
COMBINED LEVERAGE
When financial leverage is combined with operating leverage the effect of a
change in output (sales) in magnified in the change in earning per share (EPS).
Operating leverage gives us the change in EBIT with a change in sales and
financial leverage gives us the change in EPS with a change in EBIT. We cam
then see the change in EPS for a change in sales (volume of output). The
combining both concepts as can be seen below:
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Now, we can determine the effect of a change in output (sales) on earnings per
share (EPS). In this way, we can better depict the relative influence of the
two types of leverage for the firm. We can determine and examine the effect
of adding financial leverage on top of operating leverage.
or
or
Q auw t aO h n pi tc ei ht r y a t i n g
L ei c sv o e mr a p x g u e t ( ep Pdr u i −eVnc r eiac t por u eis) na rt ib t l e
Q auw t aO h n pi tc ei ht r y a t i n g
L ei C sv eo rxm(Pa pgr ui e − c utV e n adc i prot )i eus− aO rtn b piF lpt Cee i e −xrI or ane s dt t ie sn r ge s t
Calculate the degree of combined leverage for both firms:
Implication:
1. Remember that a firm with high leverage(s) will have large increases in
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EPS for changes in sales but will also have large decreases in EPS for
decreases in sales (and therefore have high risk).
2. Firms that have lower leverage(s), with have smaller increases in EPS for
the same change in sales and will have smaller decreases in EPS for the
same decrease in sales (and therefore have lower risk).
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