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MEASURES OF LEVERAGE
Presenters name
Presenters title
dd Month yyyy
1. INTRODUCTION
Leverage is the use of fixed costs in a companys cost structure.
- Operating leverage relates to the companys operating cost structure.
- Financial leverage relates to the companys capital structure.
Fixed
Costs
Fixed
Costs
2. LEVERAGE
Leverage increases the volatility of earnings and cash flows hence, it
increases risk to suppliers of capital (creditors and owners).
Consider two companies, Company One and Company Two, with the following
information:
Company Company
One
Two
Number of units produced and sold
Sales price per unit
Variable cost per unit
Fixed operating cost
Fixed financing expense
Debt
Equity
Total assets
Copyright 2013 CFA Institute
1,000
250
125
50,000
5,000
1,000
250
25
100,000
55,000
50,000
700,000
750,000
550,000
200,000
750,000
4
Company Two
200,000
150,000
100,000
50,000
Net
Income
0
- 50,000
- 100,000
- 150,000
Sales
Risk
Operatin
g Risk
Business
Risk
OPERATING RISK
Operating risk is the risk associated with the mix of variable and fixed
operating expenses.
- Operating risk is the sensitivity (i.e., elasticity) of operating earnings to
changes in unit sales.
The degree of operating leverage (DOL) is the ratio of the percentage
change in operating income to the percentage change in units sold.
The per unit contribution margin is the difference between the sales price
and the variable cost per unit. This difference is available to cover fixed
operating costs.
- Overall, for all units sold, the contribution margin is the difference between
total revenues and variable operating costs.
DOL
The DOL is at Q units produced and sold:
(4-2)
where
Qis the number of units
Pis the price per unit
Vis the variable operating cost per unit and
Fis the fixed operating cost
COMPANY ONE
COMPANY TWO
1.800
1.667%
Copyright 2013 CFA Institute
FINANCIAL RISK
Financial risk is the risk associated with the choice of financing the business.
- The greater the reliance on fixed-cost obligations, such as debt, the greater
the financial risk.
- Similar to operating risk, financial risk elasticity is the sensitivity of income
available to owners to a change in operating earnings.
The degree of financial leverage (DFL) is the ratio of the percentage change
in net income to the percentage change in operating income.
10
DFL
At a specific level of operating earnings (and, therefore, Q):
(4-4)
where Q, P, V, and F are as before, and C is the fixed financial cost.
11
Com
pany
Com
Two
pany
Two
1.786%
12
13
Company One
Company Two
14
15
Com
pany
Com
Two
pany
Two
3.214
16
BREAKEVEN QUANTITY
The breakeven point (QBE) is the level of units produced and sold at which the
costs (both variable and fixed) are just coveredthat is, net income is zero.
The breakeven point is
(4-7)
The operating breakeven point (QOBE) is the level of units produced and sold
at which the operating costs are covered.
17
Com
pany
Com
Two
pany
Two
18
19
4. SUMMARY
Leverage is the use of fixed costs in a companys cost structure.
Business risk is the risk associated with operating earnings and reflects
- sales risk (uncertainty with respect to the price and quantity of sales) and
- operating risk (the risk related to the use of fixed costs in operations).
Financial risk is the risk associated with how a company finances its operations
(i.e., the split between equity and debt financing of the business).
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SUMMARY (CONTINUED)
The degree of operating leverage (DOL) is the sensitivity of operating earnings
to changes in units produced and sold.
The degree of financial leverage (DFL) is the sensitivity of cash flows to owners
to changes in operating earnings.
The degree of total leverage (DTL) is the sensitivity of the cash flows to owners
to changes in unit sales.
The breakeven point, QBE, is the number of units produced and sold at which
the companys net income is zero.
The operating breakeven point, QOBE, is the number of units produced and sold
at which the companys operating income is zero.
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