Question

In: Finance

(a) (8 marks) Calculate the operating leverage (OL) and financial leverage (FL) for a firm with...

(a) Calculate the operating leverage (OL) and financial leverage (FL) for a firm with sales of 1,000 units with a selling price of 10$/unit, variable cost of 6$/unit, fixed costs (excluding financial charges) of 1,500$, and interest of 750$. Check your answers by using the elasticity definition of leverage and sales of 1,100 units.

(b) What is the combined leverage (O&FL) in (a)? explain what this means if volume increases by 10%.

(c) ( 2 marks) why are taxes and the number of shares irrelevant calculating FL?

Solutions

Expert Solution

1-
sales 1000*10 10000
variable cost 1000*6 6000
contribution margin 4000
fixed cost 1500
EBIT 2500
less interest 750
EBT 1750
Degree of operating leverage contribution/EBIT 4000/2500 1.6
Degree of financial leverage EBIT/EBT 2500/1750 1.428571
% change in EBIT due to change in sales =(100*10)/(1000*10) = 10% degree of operating leverage*% change in sales 1.6*10% 16%
Degree of operating leverage =% change in operating income/%change in sales 16%/10% 1.6
2-
degree of combined leverage contribution/EBT 4000/1750 2.285714
combined leverage of firm is 2.285 times which means that if volume will increase by 10% then company's earning before tax increased by (10%*2.285) 22.85%. In simple words we can say that an increase of 10% in volume will increase the earning available to shareholders by 22.85%
3-
Tax rate and no. of shares outstanding are irrelevant in calculating financial leverage because financial leverage measures the effect of financial charges on the earning before tax and how much change in operating profit would affect the before tax income of the company so tax rate and no. of share outstanding are irrelevant in calculating degree of financial leverage.

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