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Leverage: A Guide for Investors

This document discusses different types of leverage used in business including operating leverage, financial leverage, and combined leverage. It provides examples to illustrate each type. Operating leverage measures how fixed costs affect earnings and is higher for capital-intensive businesses. Financial leverage measures how interest expenses affect earnings per share and is influenced by a company's capital structure. The degree of combined leverage multiplies the effects of operating and financial leverage and shows the overall financial risk of a business.

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Ramisha
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105 views14 pages

Leverage: A Guide for Investors

This document discusses different types of leverage used in business including operating leverage, financial leverage, and combined leverage. It provides examples to illustrate each type. Operating leverage measures how fixed costs affect earnings and is higher for capital-intensive businesses. Financial leverage measures how interest expenses affect earnings per share and is influenced by a company's capital structure. The degree of combined leverage multiplies the effects of operating and financial leverage and shows the overall financial risk of a business.

Uploaded by

Ramisha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER - 05

LEVERAGE
TECHNIQUE OF COLLECTING WATER FROM DEEP WELL….!!
WHAT IS LEVERAGE ?
• Originally discovered by the scientist Archimedes.
• In general, Leverage is use of something to get maximum
advantage or we can say minimum input leading to maximum
output.

• Example, 1: Technique of collecting water from deep well….!!


• Example 2: Buying a small house at $20,000 (do not have money to buy
large house) or Buying a house at $ 1,00,000 by taking additional 80,000
dollar bank loan at 10% yearly interest rate for one year.
So after one year if house price increased BY 4 times, WHAT WOULD BE
THE IMPACT IN BOTH SCENARIO?
OPERATING LEVERAGE

• The degree of operating leverage is a measure used to evaluate how a company's


operating income changes with respect to a percentage change in its sales.
• AND also refers to change of fixed cost compare to variable costs.

High operating leverage: High operating leverage firms are capital intensive (in
a business large portion of total cost is fixed cost than variable cost)
Example: Software(large part for developers salary), Automobile (infrastructure
cost)
Firm with high operating leverage, a small change in sales results in large change
in EBIT.
• Low operating leverage: Low operating leverage usually
labor intensive (A large portion of firm’s sales are variable
cost than fixed cost).
Example: Consultation firm( pay employee by hour and collect
from clients hour basis), Coal Mining

• Firms earns small profit/EBIT on each incremental sales but


does not have to generate much sales to cover its lower fixed cost.
Fixed Cost Variable cost

Lease Raw materials

Depreciation Factory labor

Executives Salaries Sales commission

Property Taxes
 

Degree of Operating leverage (DOL) =

or
DOL = = = 2.7 x ( change in 80,000 to 1,00,000 units part)
• ( 60,000 – 36,000 = 24,000 & 1,00,000 – 80,000 = 20,000)

(80,000 units part)

DOL = = = = 2.7 x
FINANCIAL LEVERAGE
• Financial leverage refers to the use of debt to acquire additional assets or
the amount of debt used to finance a firm's assets.
• A degree of financial leverage (DFL) measures that the sensitivity of firms
earnings per share to fluctuation in its EBIT.
• Higher the DFL indicates, a small change in debt may result significant
fluctuation in EBIT.
• To much financial leverage leads to bankruptcy risk.
• The use of Financial leverage varies industry to industry.
• Industry that operates with high degrees of Financial leverage such as
Banking institutions
•• Degree
  of Financial Leverage (DFL) =
Or =

DFL = = = 1.5 x (80,000 units part)

or

DFL = = = = 1.5 x (80,000 to 1,00,000 units part)


DIFFERENCE

Operating Leverage Financial Leverage


Measure the effect of fixed operating cost Measures the effect of Interest expense

Influence on Sales and EBIT Influence on EBIT and EPS

Arises due to cost structure Arises due to capital structure

Creates Business risk Creates financial risk


DEGREE OF COMBINED LEVERAGE (DCL)

DCL = DOL * DFL


= *
=

Or DCL =
•  DCL = = = =4x
or

• DCL = =
= =4x
* Sell 2 per unit
* Variable cost = .80 per unit
(Depreciation = 40,000 taka)

Unit Sold Total Variable Fixed Total Total Revenue Operating Profit /
(1) cost (2) cost (3) Cost (4) (5) EBIT (4 – 5)

50,000 40,000 60,000 1,00,000 1,00,000 0

80,000 64,000 60,000 1,24,000 1,60,000 36,000

(80,000 * .80) ( 2 + 3) (80,000 * 2)


1,00,000 80,000 60,000 1,40,000 2,00,000 60,000

  * Break Even Point (BE) (Unit) = /


• BEP (Cash) =

 BEP = = = = 50,000 units

 BEP (cash) = = = 33,333


Exercise

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