Question

What is the relationship between operating leverage and volatility in EBIT? What is the relationship between financial leverage and volatility in EAT?

Answer 1

Operating leverage arises from the existence of fixed operating expenses. When a firm has fixed operating expenses, a 1 percent change in sales leads to more than 1 % change in EBIT. Consier the case of a firm , which is currently selling its product for $ 100 per unit. Variable costs are $ 50 per unit, and its fixed operating costs are $ 20,000.

Sales in Units	500	600
Sales Revenue	$ 50,000	$ 60,000
Variable Costs	25,000	30,000
Fixed Operating Costs	20,000	20,000
EBIT	5,000	10,000

Degree of operating leverage = $ 25,000 / $ 5,000 = 5

There is 20% increase in sales from 500 units to 600 units.

Because DOL is 5, the increase in EBIT = 20% x 5 = 100%, i.e from $ 5,000 to $ 10,000.

While operating leverage arises due to the existence of fixed operating costs, financial leverage emanates from the existence of fixed finance cost, i.e interest. When a firm has fixed interest expense, a 1 % change in EBIT leads to a more than 1 % change in EAT.

Let us consider the following example:

	Case A	Case B
EBIT	$ 50,000	$ 60,000
Interest Expense	30,000	30,000
EBT	$ 20,000	$ 30,000
Tax ( 50%)	10,000	15,000
EAT	$ 10,000	$ 15,000

DFL = EBIT / EBT = $ 50,000 / $ 20,000 = 2.5

EBIT increases from $ 50,000 to $ 60,000, an increase by 20%.

EAT increase from $ 10,000 to $ 15,000, an increase by 50%,i.e 20% x 2.5 = 50%.