Financial Analysis: Measures of Leverage
Which of the following statements about capital structure and leverage is most accurate? A) Financial leverage is directly related to operating leverage B) Increasing the corporate tax rate will not affect capital structure decisions. C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.
C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.
Which of the following is a key determinant of operating leverage? A) Level and cost of debt B) The competitive nature of the business C) The trade-off between fixed and variable costs
C) The trade-off between fixed and variable costs. The extent to which costs are fixed determines operating leverage.
If there are no interest costs
DFL is equal to one.
If there are no fixed costs
DOL is equal to one.
In the leveraged scenario
ROE is more volatile compared to EBIT.
DOL is highest
at low levels of sales and declines at higher levels of sales.
Fixed Operating expenses
building or equipment leases.
Net income at various levels
can be calculated as total revenue (price*quantity sold) minus total costs (i.e., total fixed costs plus total variable costs).
degree of total leverage (DTL)
combines the degree of operating leverage and financial leverage. It measures the sensitivity of EPS to change in sales.
operating breakeven quantity of sales
consider only fixed operating costs and ignore fixed financing costs
F
fixed costs
leverage
increases the risk an potential return of a firm's earnings and cash flows.
financial leverage
increases with fixed financing costs.
operating leverage
increases with fixed operating costs.
Fixed Financial Costs
interest payments on debt.
degree of financial leverage (DFL)
interpreted as the ratio of the percentage change in net income (or EPS) to the percentage change in EBIT.
The degree of operating leverage (DOL)
is defined as the percentage change in operating income (EBIT) that results from a given percentage change in sales.
Greater leverage
leads to greater variability of the firm's after-tax operating earnings and net income.
Financial leverage increases the
level of ROE and the rate of change for ROE
EBIT
operating income-- Earnings before interest & tax
Business risk is the combination of
operating risk and sales risk.
P
price per unit
Q
quantity of units sold
Using more debt and less equity in a firm's capital structure
reduces net income through added interest expense but also reduces net equity. The net effect can be to either increase or decrease ROE.
Financial risk
refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing.
Operating risk
refers to the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm's operating risk.
Financial risk
refers to the additional variability of EPS compared to EBIT. Financial risk increases with greater use of fixed cost financing (debt) in a company's capital structure.
Business risk
refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage.
S
sales
The use of financial leverage
significantly increase the risk and potential rewards to common stockholders.
Leverage *British refer to it as "gearing"
the amount of fixed costs a firm has.
The breakeven quantity of sales
the amount of sales necessary to produce a net income of zero (total revenue just covers total costs)
The operating breakeven quantity of sales is
the amount of sales necessary to produce an operating income of zero (total revenue just covers total operating costs)
The degree of total leverage (DTL)
the combination of operating and financial leverage and is calculated as DOL*DFL
Contribution Margin
the difference between price and variable cost per unit
the further a firm's sales are from its breakeven level of sales...
the greater the magnifying effects of leverage on net income.
breakeven quantity
the level of sales that a firm must generate to cover all of its fixed and variable costs is called the breakeven quantity.
breakeven quantity of sales
the quantity of sales for which revenues equal total costs, so that net income is zero.
Business risk
the risk associated with the firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.
The use of financial leverage increases
the risk of default, but also increases the potential return for equity holders.
Sales risk
the uncertainty about the firm's sales.
If there are no fixed costs
there is no operating leverage.
TVC
total variable costs
V
variable cost per unit
ROE & EBIT
vary directly; if one increases the other does too, same for decrease.
