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Leverage - Finance 325 Week 1 Lecture Notes Dan Parlagreco...

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Finance 325 Week 1 Lecture Notes Dan Parlagreco Welcome to the first week of Finance 325. This week we will discuss both financial and operating leverage. Capital structure can determine the amount of financial leverage, but it is important to first consider the operating leverage inherent in the firms cost structure. Firms with high fixed costs have higher operating leverage positions than firms with few fixed costs. Within each operating leverage construction lies an optimal structure for the capital financing of the firm. The theory of capital structure can help determine what this optimal structure is and how it can be achieved. Operating risk refers to financial risk. As we have studied in earilier in FIN 475, financial risk has to do with the variability of returns. Because firms with high fixed costs relative to variable costs have the possibility to make or loose larger amounts of money than firms with higher variable costs, these firms are said to be more risky. Operating risk can be determined by computing the Return on Equity (ROE) for a firm with no debt. This would isolate the operating risk from the financial risk that exists due to the capital structure of the firm. Sources of operating risk include variations in the inputs and outputs of a firm. For example, if a firm earns 10% EBIT on sales of $10MM with fixed costs of $8MM, then their variable costs must be $1MM. This is a highly rigid cost structure. Now say that their sales fall to $9MM. Since they still have fixed costs of $8MM, and variable costs are 10% of sales (1MM/10MM from the first case), their EBIT would fall to $100K, a 90% reduction due to a 10% reduction in sales.
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