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leverage_handout

# leverage_handout - OPERATING AND FINANCIAL LEVERAGE...

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OPERATING AND FINANCIAL LEVERAGE Operating Leverage —the degree to which a firm or project is committed to fixed productions costs. The higher the amount of fixed costs the higher the degree of operating leverage. If a firm has only variable  operating expenses, than by definition it has no operating leverage.   Firms that are capital intensive will have higher DOL than firms that are labor intensive.  In bad times the labor force can  be fired but the equipment would be hard to get rid of and would require maintenance, place to operate, regular  depreciations expenses ect.  The degree of operating leverage is defined as the % change in EBIT that results from a % change in sales DOL = Percentage change in EBIT Percentage change in Sales This can also be expressed in a formula developed for calculating the degree of operating leverage at any base level of sales: DOL = Sales – Variable Costs = EBIT+Fixed cost EBIT EBIT Example: consider the following scenario. What is the DOL? Existing 10% increase in sales Sales Revenue \$900,000 COGS \$300,000 Contribution margin \$600,000 Fixed costs \$200,000 EBIT \$400,000 What if we were to increase the amount of fixed cost from \$200,000 to \$300,000? \$300,000 in FC 10% increase in sales Sales Revenue \$900,000 COGS \$300,000 Contribution margin \$600,000 Fixed costs \$300,000 EBIT \$300,000 What if the company had \$300,000 of fixed costs, what would be the DOL? Financial Leverage —A firm finances part of its business with securities such as bonds, debentures, or preferred shares. These securities have fixed financing charges; the greater the reliance on borrowed money the greater the DFL. Financial leverage is the responsiveness of the earnings per share (EPS) to fluctuations in EBIT. The degree of financial leverage is defined as the %change in EPS that results from a % change in EBIT.

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leverage_handout - OPERATING AND FINANCIAL LEVERAGE...

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