, leverage , concept of leverage , types of leverage , degree of leverage , cost associate with leverage , business risk & dol

1. 9/28/2019
Leverage

2. 9/28/2019
Concept of Leverage
The ability to influence a system, or an environment, in a way
that multiplies the outcome of one's efforts without a
corresponding increase in the consumption of resources. In
other words, leverage is the advantageous condition of having
a relatively small amount of cost yield a relatively high level
of returns.
 Leverage is the use of various financial instruments or
borrowed capital, such as margin, to increase the potential
return of an investment.
 The amount of debt used to finance a firm's assets. A firm with
significantly more debt than equity is considered to be highly
leveraged.
 On the other hand, the use of fixed cost by the firm.

3. 9/28/2019
Types of Leverage
i. Operating Leverage : The use of fixed
operating costs by the firm. One potential
“effect” caused by the presence of
operating leverage is that a change in the
volume of sales results in a “more than
proportional” change in operating profit
(or loss).

4. 9/28/2019
ii. Financial Leverage : The use of fixed
financing costs by the firm. The British
expression is gearing. Used as a means of
increasing the return to common
shareholders.
iii. Combined Leverage : The use of fixed
operating and fixed financing cost.

5. 9/28/2019
Degree of Leverage
i. Degree of Operating Leverage : The
percentage change in a firm’s operating
profit (EBIT) resulting from a 1 percent
change in output (sales).
ii. Degree of Financial Leverage : The
percentage change in a firm’s earnings
per share (EPS) resulting from a 1 percent
change in EBIT.

6. 9/28/2019
iii. Degree of Combined Leverage : The
percentage change in a firm’s earnings
per share (EPS) resulting from a 1 percent
change in output (sales).

7. Cost Associate with Leverage
 Fixed Cost: A fixed cost is a cost that does not change with
an increase or decrease in the amount of goods or services
produced or sold. Fixed costs are expenses that have to be
paid by a company, independent of any business activity. It
is one of the two components of the total cost of running a
business, along with variable cost.
 Variable Cost: A variable cost is a corporate expense that
varies with production output. Variable costs are those costs
that vary depending on a company's production volume;
they rise as production increases and fall as production
decreases. VC differ from FC such as rent, advertising,
insurance and office supplies, which tend to remain the
same regardless of production output. Fixed costs and
variable costs comprise total cost.

9/28/2019

8. Cost Associate with Leverage
 The weighted average cost of capital (WACC) is the
rate that a company is expected to pay on average to all
its security holders to finance its assets. The WACC is
commonly referred to as the firm's cost of capital.
Importantly, it is dictated by the external market and not
by management.
 Marginal cost of capital (MCC) schedule is a graph that
relates the firm's weighted average cost of each unit of
capital to the total amount of new capital raised.
9/28/2019

9. 9/28/2019
Business Risk & DOL
Business risk refers the variability of the
firm’s operating income (EBIT) due to change
in sales unit, sales price and cost structure.
DOL is only one component of business risk
and becomes “active” only in the presence of
sales unit variability.
DOL magnifies the variability of operating
profits and, hence, business risk.