10 Leverage - handout

10 Leverage - handout - THE TWO-EDGED SWORD Mind Map In the...

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THE TWO-EDGED SWORD
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Mind Map In the physical sciences, “leverage” refers to the ability to magnify effort. In finance, we borrow this term and use it in a similar way to describe the impact of fixed costs Leverage refers to the magnification of operating or financial results from the use of fixed costs Two flavors: operating and financial leverage
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Mind Map Learning objective: Develop an understanding of what creates operating and financial leverage Describe the impact of leverage on operating profits and net income/EPS Distinguish between operating leverage and financial leverage Measure the amount of leverage inherent in a firm’s operations Predict the impact of changes in sales or operating profits
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Mind Map Key words/concepts: Financial leverage, operating leverage DOL, DFL, DCL Fixed cost, break-even, contribution margin
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Two sources of risk 1) Business (or Operating) Risk - variability associated with operating income. 2) Financial Risk - risk of distress or bankruptcy due to the use of fixed cost financing.
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Business Risk Affected by: Sales volume variability, Competition, Cost variability, Product diversification, Product demand Operating Leverage.
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Operating Leverage The use of fixed operating costs as opposed to variable operating costs. A firm with relatively high fixed operating costs will experience more variable operating income if sales change.
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Costs Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).
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Quantity { $ Total Revenue Total Cost FC
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Quantity { $ Total Revenue Total Cost FC Break- even point }EBIT }EBIT Q 1 + -
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10 Leverage - handout - THE TWO-EDGED SWORD Mind Map In the...

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