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Cf Leverage 7 C
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FINANCE,CFM

FINANCE,CFM

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  • 1. Leverage
    • Use of fixed costs to increase profitability
    • Magnify returns by taking on additional risks.
    • Operating leverage
    • Financial leverage
  • 2. Operating Leverage
    • Reflects the extent to which fixed assets and associated fixed costs are utilised
    • Fixed operating costs – do not vary as sales volume changes.
    • Depreciation. Insurance. Salaries.
    • Change in volume results in a more than proportionate change in operating profit
    • Airlines. Hotel.
  • 3. Operating Leverage
    • How much will changes in volume affect profits and costs
    • At what point does the firm break even
    • What is the most efficient level of fixed assets to employ in the firm.
    • Double edged sword. Greater variability of earnings.
  • 4. Operating Leverage
    • Firm F Firm V
    • Fixed Costs Proportion 0.78 0.22
    • Sales 10000 10000
    • Fixed cost 7000 2000
    • Variable cost 2000 7000
    • Operating profit 1000 1000
    • Sales 15000 15000
    • Fixed cost 7000 2000
    • Variable cost 3000 10500
    • Operating profit 5000 2500
  • 5. Degree of Operating Leverage
    • Percentage change in operating profit to percentage change in volume
    • Different at different volumes
    • DOL = Q(P-V)/ (Q(P-V)-FC)
    • (Sales –variable cost) divided by (sales –variable costs –fixed costs)
  • 6. High Operating Leverage Fixed Costs = Rs. 60000 Variable Costs = Rs.0.80 per unit Revenues = Rs. 2 per unit BE = Fixed Costs / Contribution per Unit = FC / (Price – VC) = 60000 / (2- 0.8) = 50000 units
  • 7. Low Operating Leverage Fixed Costs = Rs. 12000 Variable Costs = Rs.1.60 per unit Revenues = Rs. 2 per unit BE = Fixed Costs / Contribution per Unit = FC / (Price – VC) = 12000 / (2- 1.6) = 30000 units
  • 8. Volume-cost-profit analysis: Leveraged firm 60000 200000 140000 60000 80000 100000 36000 160000 124000 60000 64000 80000 12000 120000 10800 60000 48000 60000 0 100000 100000 60000 40000 50000 (12000) 80000 92000 60000 32000 40000 (36000) $40000 76000 60000 $16000 20000 $(60000) 0 $60000 $60000 0 0 Operating Income ( Loss) Total Revenue Total Costs Fixed Costs Total Variable Costs Units Sold
  • 9. Volume-cost-profit analysis: Conservative firm 28000 200000 172000 12000 160000 100000 20000 160000 140000 12000 128000 80000 12000 120000 108000 12000 96000 60000 4000 80000 76000 12000 64000 40000 0 60000 60000 12000 48000 30000 (4000) $40000 44000 12000 $32000 20000 (12000) 0 $12000 $12000 0 0 Operat ing Inc ( Loss) Total Revenue Total Costs Fixed Costs Total Variable Costs Units Sold
  • 10. Operating Income or Loss 60000 36000 12000 (12000) (36000) $(60000) Leveraged Firm 28000 20000 12000 4000 (4000) $(12000) Conservative Firm 100000 80000 60000 40000 20000 0 Units
  • 11. Financial leverage
    • Reflects the extent to which debt is used in meeting the required funds
    • Use of fixed cost financing (Debt)
    • Matter of choice
    • What will be the impact of changes in operating profit on earnings per share
    • What is the most efficient level of debt to employ in the company
  • 12. Total Leverage
    • How sensitive are earnings per share to changes in sales
    • Degree of total leverage equals percentage change in EPS to percentage change in sales
    • DTL = DOL * DFL
  • 13. Impact of Leverage
    • Variability of earnings
    • Fixed obligations of payment
    • Higher chances of loss
    • Increased probability of bankruptcy
  • 14. Limitations
    • Division of costs between fixed and variable
    • Non linear function of revenues and costs
  • 15. Concepts
    • Leverage represents the use of fixed-costs items to magnify the firm’s results.
    • Operating leverage indicates the extent fixed assets are utilized by the firm.
    • By increasing leverage, the firm increases its profit potential, but also its risk of failure.
    • Financial leverage shows how much debt the firm employs in its capital structure.
  • 16. Applications
    • Revenue Management – Pricing decisions
    • Capital structure decisions
    • Impact on value