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Operating+Leverage+and+Beta - times the quantity sold and...

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H AAS S CHOOL OF B USINESS UGBA 103 U NIVERSITY OF C ALIFORNIA AT B ERKELEY A VINASH V ERMA O PERATING L EVERAGE AND THE S YSTEMATIC R ISK Let us denote periodic (typically annual) cash flows that the firm projects as CFs , (periodic) Revenues as , (periodic) Fixed Costs as , and (periodic) variable costs as . Now, in every period in the future cash flows are revenues less fixed and variable costs. Therefore, we can say that: (1) Based on this observation, we can think of the assets, , as a portfolio in which a fraction has been invested in the Revenues, a fraction has been invested in the variable costs, and a fraction has been invested in the fixed costs. Now, because beta of a portfolio is a sum of the beta of the constituents of the portfolio weighted with the fraction invested in each constituent: Now, since fixed costs are fixed (at least in the short run), . Revenues equal price
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Unformatted text preview: times the quantity sold, and variable costs equal cost times the quantity produced. If the profit margin and working capital (particularly accounts receivable) do not change from period to period, . Therefore: Operating Leverage and Beta 1 where in the last step follows from Equation (1) above. Therefore: (2) The quantity is known as the operating leverage. It also follows that , and the extent to which the inequality holds depends on the operating leverage. The equation above suggests that we can estimate beta of the assets when we have information on the systematic risk of the firm’s revenues as measured by the beta of its revenues, or, in other words, information on how the changes in revenue move together with changes in the market....
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