336 Leverage - Leverage I. A. Business and Financial Risk...

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Leverage I. Business and Financial Risk A. General Observations: Value = CF 1 + CF 2 + + (1+ wacc) (1+ wacc) By definition, risk is the uncertainty in the future cash flows. When discussing sources of risk, we think of things that cause volatility in cash flow (or earnings, NI, EBIT, ROE, or other similar measures). B. Business Risk Business risk is the variability in cash flows to the firm (and variability in shareholder ROE) that is due macro-economic factors, industry characteristics, and fixed operating costs. Sources: Demand uncertainty Sales price variability Input cost variability Exposure to macro-economic factors Market dominance Pricing power Operating Leverage Etc. Operating leverage Example: Two firms, each face 2 possible sales levels. One firm has low operating leverage (LOL) and the other has high operating leverage (HOL). LOL HOL Sales Revenue 10,000 12,000 10,000 12,000 VC 2,000 2,400 1,000 1,200 FC 3,000 3,000 4,000 4,000 EBIT 5,000 6,600 5,000 6,800 OL = (6,600 – 5,000)/5,000 OL = (6,800 – 5,000)/5,000 (12,000-10,000)/10,000 (12,000-10,000)/10,000 = 1.6 = 1.8 HOL has a higher degree of operating leverage. For a single percentage change in Sales Revenue from the current level of 10,000, there will be a 1.8 percent change in EBIT. Operating Leverage (part of Business Risk) Fin 336, Leverage, p. 1
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Two firms: Same sales revenue but different fixed and variable costs. LOL: Low fixed costs (HOL): High fixed costs LOL HOL Price/unit (P) $80 $80 Variable Cost/unit (VCU) $60 $40 Fixed Cost (FC) $30,000 $120,000 Income Statement 4,500 units sold (Q) LOL HOL Revenues (R) Variable costs (VC) Fixed costs (FC) EBIT $360,000 $270,000 $30,000 $60,000
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336 Leverage - Leverage I. A. Business and Financial Risk...

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