Operating Leverage - . Revenues equal price times the...

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Operating Leverage and the Systematic Risk Let us denote the cash flows as CFs, Revenues as R, Fixed Costs as FC, and variable costs as VC. 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, A, as a portfolio in which a fraction PV(R)/A has been invested in the Revenues, a fraction – PV(VC)/A has been invested in the variable costs, and a fraction – PV(FC)/A 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,
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Unformatted text preview: . Revenues equal price 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: However, from Equation (1) above, . Therefore: The quantity PV(FC)/A is known as the operating leverage. The equation above says that . It also suggests that we can estimated beta of the assets when we have information on the systematic risk of the firms 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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