Professional Documents
Culture Documents
Leverage
Financial Risk
Factors indicating financial risk
Operating Leverage
Financial Leverage
Effects of Operating and Financial Leverage
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Combined Leverage
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Firm risk
RISK means the potential variability in future cash
flows.
Total firm risk = Business risk + Financial risk
Business risk
the amount of variability in the firms expected
EBIT.
is the risk inherent in producing a good or service
as measured by the variability in the firms
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expected EBIT.
Extent of product
diversification
Firms growth rate
Degree of operating
leverage (DOL)
Both systematic and
unsystematic risk
Financial Risk
Factors indicating financial risk
Debt-to asset ratio
Debt-to-equity ratio
Fixed charge coverage ratio
Times interest earned ratio
Probability distribution of profits
Both systematic and unsystematic risk
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Operating Leverage
Is the responsiveness of the firms EBIT to
changes in sales
Arises from the firms use of fixed operating
costs
excluding interest
Influences on business risk
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DOL at X =
EBIT = Sales - VC - FC
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Operating Leverage:
Example
DOL measures a potential risk or risk profile
To contemplate altering a firms cost structure a
manager should have an understanding of the
operating leverage concept.
E.G: labour force versus capital equipment decision
As capital equipment replaces part of labour force
in the production process,
fixed costs tend to increase ...
so operating leverage increases
Financial Leverage
Is the responsiveness of the firms NI or EPS to
changes in EBIT
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DFL at X =
EBIT - I - Dp / (1 - T )
% change in EBIT
EBIT
EBIT- I Dp / (1-T)
Leverage Model
% Sales
DOL
% EBIT
DFL
% EPS
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Financial Leverage
A change in EBIT is
magnified into a
relatively large
change in EPS
See leverage
model
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Combined Leverage
Is the responsiveness of a firms NI (or EPS) to
changes in sales
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Combined Leverage
DCL = % change in NI
= contribution margin
% change in Sales
EBIT- I Dp / (1-T)
the greater the sales level,
the lower the degree of combined leverage (DCL)
and vice versa
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DCL Model
.
% Sales
DOL
% EBIT
DCL
DFL
% NI or EPS
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