Question

Question 4

(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?

Answer 1

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.