B3-FINANCIAL MANAGEMENT-LEVERAGE

Question 1

Financial Mgmnt

Leverage

What is it?

Answer 1

Affects the variability of company profits and therefore, affects the risk assumed (and return required) by creditors and owners.

Question 2

Financial Mgmnt

Leverage

Operating Leverage-what is it and which industries have high vs low operating leverage?

Answer 2

Is the degree to which a company uses fixed operating costs rather than variable operating costs.

Capital intensive industries often have high operating leverage.

Labor Intensive industries generally have low operating leverage.

Question 3

Financial Mgmnt

Leverage

Operating Leverage

Implications

Answer 3

DOL: % change EBIT / % change in sales

A company with higher operating leverage must produce sufficient sales revenue to cover its high fixed operating costs. High OL is beneficial when sales revenue is high. High contribution margin indicates high operating leverage.

high operating leverage will have greater risk but greater possible returns. Variability of profits is greater with higher operating leverage. When sales decline, a company with high operating leverage may struggle to cover fixed costs. However, beyond the breakeven point, a company with higher fixed costs will retain a higher % of additional revenues as operating income.

Question 4

Financial Mgmnt

Leverage

Operating Leverage

Example of high operating leverage

Answer 4

Company A experiences 21% increase in EBIT as a result of a 5% increase in sales, while competitor had 10% increase in EBIT as a result of 5% increase in sales.

DOL= +21% / +5%=4.2 vs DOL= +10% / +5%=2

Company A has higher operating leverage than the competitor, which implies that FC consitute a higher proportion of Company A’s total costs. Company A needs to generate more revenue to cover its fixed costs, but will be highly profitable once those FC are met.

Question 5

Financial Mgmnt

Leverage

Financial Leverage

What is it and implications and formula?

Answer 5

What is it?

Is the degree to which a company uses debt rather than equity to finance the company.

Implications

A company that issues debt must produce sufficient operating income (EBIT) to cover its fixed interest costs. However, once fixed interest costs are covered, additional EBIT will go straight to net income and EPS. A high degree of financial leverage implies that a relatively small change in earnings before interest and taxes (increase or decrease) will have a greater effect on profits and shareholder value.

Another benefit is that interest costs are tax deductible, whereas dividends are not.

Formula

DFL = %change in EPS / %change in EBIT