Reading 34: Measures of Leverage

Question 1

Mathematically state the Degree of Operating Leverage (DOL) and describe the insights that it gives.

Answer 1

DOL=(Q×(P‒V))/((Q×(P‒V)‒F)

Q = Number of units sold
P = Price per unit
V = Variable operating cost per unit
F = Fixed operating cost
DOL is negative when operating income (the denominator in the DOL equation) is negative and is positive when the company earns operating profits.

Operating income is most sensitive to changes in sales around the point where the company makes zero operating income.

DOL is undefined when operating income is zero.

Question 2

How is financial risk measured?

Answer 2

As the sensitivity of cash flows available to owners to changes in operating income. This measure is known as the degree of financial leverage (DFL).

Question 3

Describe the 2 main types of bankruptcy protection.

Answer 3

Reorganization (Chapter 11), which provides the company temporary protection from creditors so that it can reorganize its capital structure and emerge from bankruptcy as a going concern.

Liquidation (Chapter 7), which allows for an orderly settlement of the creditors’ claims. In this category of bankruptcy, the original business ceases to exist.

Question 4

Explain why it is important for analysts to understand a company’s use of leverage.

Answer 4

Leverage increases the volatility of a company’s earnings and cash flows, thereby increasing the risk borne by investors in the company.

The more significant the use of leverage by the company, the riskier it is, and therefore, the higher the discount rate that must be used to value the company.

A company that is highly leveraged risks significant losses during economic downturns.

Question 5

Identify the 2 types of costs generally incurred by companies.

Answer 5

Variable costs vary with the level of production and sales.

Fixed costs remain the same irrespective of the level of production and sales.

Question 6

What is the equation for a company’s breakeven point and when does it occur?

Answer 6

PQ=VQ+F+C

P = Price per unit
Q = Number of units sold
V = Variable cost
F = Fixed cost
C = Fixed financial cost
At the number of units produced and sold at which its net income equals zero. It is the point at which a company's revenues equal its total costs and the company goes from making losses to making profits.

Question 7

What is included in fixed costs?

Answer 7

Operating costs

Financial costs