Measures Of Leverage

Question 1

What does financial leverage and operating leverage mean

Answer 1

Financial leverage consists of mostly interest rates on debt which mainly influences the capital structure of a firm, the higher debt in a capital structure the more it has Financial leverage
While, the operating leverage mostly determined by the cost structure of the firm( variable and fixed costs) the more fixed costs a firm has compared to variable costs (leases, depreciation, insurance payments, rent) the more operating leverage it has , which in turn increases operating risk.

Question 2

What happens to the volatility of earnings, cash flows and ROE as financial and operating leverage increases.

Answer 2

The volatility increases and magnifies the eps variability

Question 3

Define business risk

Answer 3

The risk associated with the uncertainty of revenues from sales( mostly affected by the elasticity of demand, the cyclicality of a firm and the industry it operates in) this covers the SALES RISK
In addition to the risk associated to the cost structure of the firm, which is the OPERATING RISK

Question 4

What risks does the beta of a company reflect

Answer 4

Business and financial risks

Question 5

Define financial risk

Answer 5

Financial risk is associated with any fixed costs or any fixed financing costs. Equity is excluded in financial risk as it isn’t a fixed cost

Question 6

Define leverage

Answer 6

Leverage is the amount of fixed costs a company uses. Which includes both financial and operating leverage

Question 7

What does the breakeven (total breakeven) present and what does the operating breakeven present

Answer 7

The breakeven point is the total amount of quantity produced to cover the total fixed and operating costs, is the amount of quantity needed for a EBT of 0, while the operating break even point presents the quantity needed to cover only the operating fixed costs, which is the quantity needed for a 0 EBIT or operating profit. A firm with 0 interest costs will have a breakeven point equal to the operating breakeven point.

Question 8

The effect of using Financial leverage instead of using purely equity financing causes what sorts of changes

Answer 8

Decreases net income (more interest expense) and increases the ROE ( shareholders equity will decrease in response to an increase in debt financing)

Question 9

What is the denominator in the breakeven quantity of sales

Answer 9

The contribution Margin per unit

Question 10

Which is easier to manage financial fixed costs or operating fixed costs

Answer 10

Financial fixed costs are easier to manage