Question

Briefly explain the concept of operating leverage. If a company takes actions that reduce its operating leverage, how is it going to affect the equity beta of the company? Why?

Answer 1

Definition: Operating leverage measures the degree to which a company can increase operating income by increasing revenue. A business that generates sales with a higher gross margin (and lower variable costs) has high operating leverage.

Formula: Degree of operating leverage = Contribution Margin / Profit. Note that this is profit before interest and taxes.

Explanation: The operating leverage formula is used to calculate a the break-even point and set appropriate selling prices to cover all variable and fixed costs and make a surplus. The formula can reveal how well a company is using its fixed-cost items such as the plant and machinery.

Impact of Operating Leverage on Equity Beta: Operating leverage can reduce if the selling price is reduced or variable cost is increased or if fixed costs (other than interest) are reduced. But usually it only means that the company has reduced the fixed costs. In other words, this increases a company's Profit before interest and taxes [EBIT]. Now, the debt services in the income statement, being Interest, now being lesser in proportion to the EBIT than before. This can be understood to increase the Equity Beta because Beta of Debt is zero, and the Earnings increases on account of reduction in operating leverage. But there is no direct correlation.