Leverage___handouts

Leverage___handouts - THE TWO-EDGED SWORD Analysis and...

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Unformatted text preview: THE TWO-EDGED SWORD Analysis and Impact of Leverage Two sources of risk 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. Business Risk Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM FIRM EBIT EPS Stock- Stock- holders holders Business Risk Business Risk The variability or uncertainty of a firms operating income (EBIT). FIRM FIRM EBIT EPS Stock- Stock- holders holders Business Risk Business Risk Affected by: Sales volume variability, Competition, Cost variability, Product diversification, Product demand Operating Leverage. Operating Leverage 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. Costs 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). Quantity $ Breakeven Analysis Breakeven Analysis Quantity Quantity $ $ Total Revenue Total Revenue Quantity Quantity { { $ $ Total Revenue Total Revenue Total Cost Total Cost FC FC Quantity Quantity { { $ $ Total Revenue Total Revenue Total Cost Total Cost FC FC Break- Break- even even point point }EBIT }EBIT Q 1 +- Operating Leverage Operating Leverage What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs? Quantity Quantity { { $ $ Total Revenue Total Revenue Total Cost Total Cost = Fixed = Fixed FC FC Break- Break- even even point point } } Q Q 1 1 + +-- EBIT EBIT Quantity...
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Leverage___handouts - THE TWO-EDGED SWORD Analysis and...

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