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Learning outcome
define and explain leverage, business risk, sales risk, operating
risk, and financial risk, and classify a risk, given a description;
calculate and interpret the degree of operating leverage, the
degree of financial leverage, and the degree of total leverage;
describe the effect of financial leverage on a companys net
income and return on equity;
calculate the breakeven quantity of sales and determine the
company's net income at various sales levels;
calculate and interpret the operating breakeven quantity of sales.
Leverage
Leverage results from the use of fixed cost assets or funds to magnify
returns to the owners
Increase in leverage results in increase in return and risk (High DCF)
Decrease in Leverage results in decrease in return and risk(Less DCF)
Risk associated with future earnings & cash flows of a company are
affected by the companys cost structure
VC & FC
Sales
price
varia
bility
Abilit
y to
devel
op
new
produ
cts
Financial Risk
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage
Dema
nd
varia
bility
Forei
gn
excha
nge
expos
ure
Input
cost
varia
bility
Opera
ting
lever
age
Operating Leverage
Operating Income Elasticity
Operating leverage is the use of fixed costs rather than variable
costs
If most costs are fixed, hence do not decline when demand falls,
then the firm has high operating leverage.
Rev.
Rs
TC
Rs
} Profit
TC
FC
FC
QBE
Sales
QBE
Sales
9
Low operating leverage
Probability
EBITL
EBITH
DOL
% change in Operating income (EBIT) that results from a given %
change in sales
Interpretation of DOL
DOL is a quantitative measure of the sensitivity of a firms
operating profit to a change in the firms sales.
The closer that a firm operates to its break-even point, the higher
is the absolute value of its DOL.
When comparing firms, the firm with the highest
DOL is the firm that will be most sensitive to a change in sale
DOL is only one component of business risk and becomes active
only in the presence of sales and production cost variability
e.g.
Calculate and interpret the DOL for A and B
A
Price
$4
$4
Variable cost
$3
$2
Fixed cost
$40,000
$120,000
Revenue
$400,000
$400,000
DFL
% change in net income or EPS to the % change in EBIT
e.g.
From the previous example As operating income for selling
100,000 units is $ 60,000. Assume that A company has an annual
interest expense of $ 18,000. If As EBIT increases by 10% by how
much will its earnings per share increases.
DTL
DTL combines the DOL and DFL