Question

(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

	Income Statement	Quantity	Per Unit	Amount	Quantity	(a)
A	Sale	1000	$          10	$     10,000	1100	$ 11,000
B	Variable Cost	1000	$            6	$       6,000	1100	$    6,600
C	Contribution (A - B)		$        4	$       4,000		$ 4,400
D	Fixed Costs			$       1,500		$ 1,500
E	Earnings Before Interest and Taxes			$       2,500		$ 2,900
F	Interest			$          750		$    750
G	Earnings before Taxes			$       1,750		$ 2,150

i.	Degree of Operating Leverage (C/E)	1.60
ii.	Degree of Financial Leverage (E/G)	1.43
iii.	Combined Leverage (C/G) or (i*ii)	2.29

Percentage Change in Sales = (1100 - 1000) / 1000 = 10%

Percentage Change in EBIT = (2900 - 2500) / 2500 = 16%

Percentage Change in EBT = (2150 - 1750) / 1750 = 22.857%

As per Elasticity Definition, Operating Leverage = % Change in EBIT / % Change in Sales

Operating Leverage = 16% / 10%

Operating Leverage = 1.6

As per Elasticity Definition, Financial Leverage = % Change in EBT / % Change in EBIT

Financial Leverage = 22.857% / 16%

Financial Leverage = 1.43

As per Elasticity Definition, Combined Leverage = % Change in EBT / % Change in Sales

Combined Leverage = 22.857% / 10%

Combined Leverage = 2.29

Elasticity definition is verified and it holds good.

Combined Leverage says that, the percentage change in EBT for a given percentage change in sales. If the Sales volume increases by 10%, EBT will increase by (2.229 * 10%) = 22.29%.

EBT at Sales 1000 Units = $ 1,750

For 10% increase in Sales, EBT using Combined leverage should be $2,150

(c) Financial Leverage measures risk on account of presence of debt in capital structure, as it requires compulsory financial charges. It doesnot deal with taxes and number of shares.

Hence, taxes and the number of shares are irrelevant for calculating FL.