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Operating leverage occurs any time a firm has fixed cost that must be met regardless of
volume. operating leverage is the technique of magnifying the EBIT by using fixed costs
that must be met regardless of volume in the capital structure. An entrepreneur generally
employ assets with a fixed cost in the hope that volume will produce revenues more than
sufficient to cover all fixed and variable costs. For example in an airline industry, a large
portion of total cost are fixed. B1eyond the break-even point each additional passenger
represents essentially straight profit to the airline. So is the case of a bus or railway and so
on. With fixed costs, the percentage change in profit accompanying a change in volume is
greater than the percentage change in volume. This occurace is known as operating
leverage. Operating leverage can be explained better by means of break-even or costvolume-profit analysis.
Financial Leverage may be defined as the use of fixed financial charges in the firms
capital structure to magnify the Earning Per Share. Financial leverage occurs when
funds with charges, such as debt and preference share are used with the owners
equity in the capital structure. The financial leverage is employed by a company with
an intention to earn more on fixed charges funds than their costs. It amy be compared
to a fulcrum used in physics in the sense that the surplus over interest cost will be
used as a lever or fulcrum to increase the return on the owners equity which is
projected by an increase in the EPS. For example, if a company borrows tk. 100 at
10 per cent interest. This is also termed as trading on the equity in the sense that
here the owners equity is used as a basis to raise debt.
Financial Leverage
Financial Leverage may be defined
as the use of fixed financial charges
in the firms capital structure to
magnify the Earning Per Share.
2.Relationship
the
3. Sources
4. Projection
5. Calculation
6. Avoidability
7. Existence
8. Creation of risk
9. Favourable
If sale exceeds BEP or, Sales price If cost of borrowed is less than the
rises or, variable cost decreases
cost of equity
leverage
10.Justification of use
11. Benefit
PROBLEM ON LEVERAGE
Balance Sheet of Harding Co as on 31st December 2005
Particulars
Current Assets
Net Fixed Assets
Total Assets
Amount
3,00,000
5,00,000
8,00,000
Particulars
Debt Capital (10%)
Common Stock
Total Capital
Amount
2,00,000
6,00,000
8,00,000
Other information
Particulars
Sales of Tooth Brush 20000 units@ tk. 20 each)
Less: Variable cost @ tk. 10 p.u.
Fixed cost (operating)
taxes (40%)
Taka
4,00,000
2,00,000
80,000
SOLUTION:
Sales in Units
Sales of Tooth Brush 20000 units@
tk. 20 each)
Less: Variable cost @ tk. 10 p.u.
20,000 Units
tk. 4,00,000
tk. 2,00,000
Contribution
Less fixed cost (operating)
tk. 2,00,000
tk 80,000
tk. 3,00,000
tk. 80,000
tk. 1,20,000
tk. 20,000
tk. 2,20,000
tk. 20,000
tk. 1,00,000
tk. 40,000
tk. 60,000
tk. 10
tk. 2,00,000
tk. 80,000
tk, 1,20,000
tk. 20
= 83.33%
20 10 X 100
10
= 100%
50%
CM
EBIT
PercentageChangeinEBIT
Percentagechangeinslaes
2,00,000
=1.67 times
1,20,000
83.33
= 1.67 times
50%
EBIT
EBT
PercentageChangeinEPS
PercentagechangeinEBIT
1,20,000
=1.2 times
1,00,000
100
= 1.2 times
83.33
DOL X DFL
1.67 X 1.2 = 2 times
PercentageChangeinEPS
PercentagechangeinSales
100
= 2 times
50