Cf Leverage 7 C

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Cf Leverage 7 C

  1. 1. Leverage <ul><li>Use of fixed costs to increase profitability </li></ul><ul><li>Magnify returns by taking on additional risks. </li></ul><ul><li>Operating leverage </li></ul><ul><li>Financial leverage </li></ul>
  2. 2. Operating Leverage <ul><li>Reflects the extent to which fixed assets and associated fixed costs are utilised </li></ul><ul><li>Fixed operating costs – do not vary as sales volume changes. </li></ul><ul><li>Depreciation. Insurance. Salaries. </li></ul><ul><li>Change in volume results in a more than proportionate change in operating profit </li></ul><ul><li>Airlines. Hotel. </li></ul>
  3. 3. Operating Leverage <ul><li>How much will changes in volume affect profits and costs </li></ul><ul><li>At what point does the firm break even </li></ul><ul><li>What is the most efficient level of fixed assets to employ in the firm. </li></ul><ul><li>Double edged sword. Greater variability of earnings. </li></ul>
  4. 4. Operating Leverage <ul><li>Firm F Firm V </li></ul><ul><li>Fixed Costs Proportion 0.78 0.22 </li></ul><ul><li>Sales 10000 10000 </li></ul><ul><li>Fixed cost 7000 2000 </li></ul><ul><li>Variable cost 2000 7000 </li></ul><ul><li>Operating profit 1000 1000 </li></ul><ul><li>Sales 15000 15000 </li></ul><ul><li>Fixed cost 7000 2000 </li></ul><ul><li>Variable cost 3000 10500 </li></ul><ul><li>Operating profit 5000 2500 </li></ul>
  5. 5. Degree of Operating Leverage <ul><li>Percentage change in operating profit to percentage change in volume </li></ul><ul><li>Different at different volumes </li></ul><ul><li>DOL = Q(P-V)/ (Q(P-V)-FC) </li></ul><ul><li>(Sales –variable cost) divided by (sales –variable costs –fixed costs) </li></ul>
  6. 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. 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. 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. 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. 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. 11. Financial leverage <ul><li>Reflects the extent to which debt is used in meeting the required funds </li></ul><ul><li>Use of fixed cost financing (Debt) </li></ul><ul><li>Matter of choice </li></ul><ul><li>What will be the impact of changes in operating profit on earnings per share </li></ul><ul><li>What is the most efficient level of debt to employ in the company </li></ul>
  12. 12. Total Leverage <ul><li>How sensitive are earnings per share to changes in sales </li></ul><ul><li>Degree of total leverage equals percentage change in EPS to percentage change in sales </li></ul><ul><li>DTL = DOL * DFL </li></ul>
  13. 13. Impact of Leverage <ul><li>Variability of earnings </li></ul><ul><li>Fixed obligations of payment </li></ul><ul><li>Higher chances of loss </li></ul><ul><li>Increased probability of bankruptcy </li></ul>
  14. 14. Limitations <ul><li>Division of costs between fixed and variable </li></ul><ul><li>Non linear function of revenues and costs </li></ul>
  15. 15. Concepts <ul><li>Leverage represents the use of fixed-costs items to magnify the firm’s results. </li></ul><ul><li>Operating leverage indicates the extent fixed assets are utilized by the firm. </li></ul><ul><li>By increasing leverage, the firm increases its profit potential, but also its risk of failure. </li></ul><ul><li>Financial leverage shows how much debt the firm employs in its capital structure. </li></ul>
  16. 16. Applications <ul><li>Revenue Management – Pricing decisions </li></ul><ul><li>Capital structure decisions </li></ul><ul><li>Impact on value </li></ul>

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