Operating Leverage

Prepared by: Roll No. Harikrushan chakalasiya 15 Sapna Parmar 16

Guidedby: Gayatri

Mohanty.

Introduction

Whenever a firm makes a capital budgeting decision (long term investment decision), it will also have to make a subsequent financing decision. It means when a firm thinks of investing or making a capital expenditure, it will thinks of from where to obtain the funds for the investment. And, then the firm will also have to decide that whether the firm should employ Equity; or Debt; or A combination of both In case the firm decides on a mix of debt and equity, then the next question is in what proportion? or the Capital Structure.

Introduction

Projects of a firm may be financed by

increasing owners claims, or increasing creditors claims, or increasing both

Owners claims will increase by

selling additional equity shares, or retaining earnings

Creditors claims borrowings.

will

increase

by

more

Capital Structure

The term capital structure is used to represent the proportionate relationship between various longterm sources of financing, such as equity capital, retained earnings, preference capital, debentures and long-term loans. More popularly the term capital structure represents the proportionate relationship between debt and equity. Equity includes paid-up share capital, share premium and reserves and surplus (retained earnings).

LEVERAGE

The term leverage means the use of a lever to move something up with reduced efforts. Leverage therefore means the gain of advantage by the use of a lever.
In corporate finance the term leverage connotes the use of an asset or source of finance for which the firm has to pay a fixed cost or fixed return.

LEVERAGE
Leverage are of two types: Financial leverage (financing decisions) The use of fixed charges sources of funds (debt and preference capital) along with owners equity in the capital structure is described as trading on equity or gearing or financial leverage.

It is known as trading on equity as debt and preference capital are raised on the basis of equity. Operating leverage (investment decisions)

Operating leverage (investment decisions)

Operating Leverage

Existence of fixed costs in the cost structure of a firm gives rise to operating leverage (O.L.). A firm will have no operating leverage if it has no fixed costs and all costs are variable. For such a firm, a given percentage change in sales would give rise to the same percentage change in operating profits or EBIT. If a firm has fixed costs, it would have operating leverage. For a given change in sales, there would be a more than proportionate change in EBIT. However, if volume of sales falls, a firm with high operating leverage would suffer more loss than a firm with no or low operating leverage. Thus, operating leverage is a doubleedged sword. It can cut both ways.

Operating Leverage

Therefore, the operating leverage can be defined as the tendency of the net operating profits to vary disproportionately with sales. The higher the operating leverage, the higher the variability of operating profits for a given variability in sales. This is referred to as operating risk.

 Operating leverage relates to the result of different combinations of

fixed costs and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage. If a company's variable costs are higher than its fixed costs, the company is said to be using less operating leverage. The way that a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is said to be highly leveraged. On the other hand, a firm with a high volume of sales and lower margins is said to be less leveraged.

What are the risks of having operating leverage ?

Degree Of Operating Leverage (DOL):

DOL is defined as the percentage change in EBIT resulting from a given percentage change in sales. It is given by :

% change in EBIT DOL % changein Sales EBIT Sales EBIT Sales

Degree Of Operating Leverage (DOL):

An alternate formula for DOL is:

Contribution DOL EBIT Q(S V ) Q(S V ) F

Where: Q is quantity of output S is the selling price per unit V is the variable cost per unit F is the total fixed costs

Combined Leverage
Also referred to as Composite Leverage it is both operating and financial leverages combined. It shows the effect of change in sales over the change in EPS. Combined Leverage = Operating X Financial leverage leverage

Combined Leverage
O.L. & F. L. together cause wide fluctuations in EPS for a given change in sales. If a company employs high levels of O.L. & F. L., even a small change in sales will have a dramatic effect on EPS.
The degree of combined leverage (DCL) =
% change in EBIT % change in EPS % change in EPS % change in Sales % change in EBIT % change in Sales

Operating Leverage

Example : Firms Y and Z manufacture the same product. Selling price per unit is Rs.8 for both the firms. Fixed costs are Rs.80,000 and Rs.2,00,000 respectively for the two firms. Variable cost per unit is Rs.6 and Rs.4 respectively. What are the break-even points for the two firms? How much profits are earned by the firms if sales range between 20,000 and 80,000 units? Rs.80,000 Break Even Points: For Y : Rs.8 Rs.6 40,000 units
Rs.2,00,000 For Z : 50,000 units Rs.8 Rs.4

Thank You