Question

Two firms, Green and Red, from the same industry reported the following income statements.

Green, Inc.	2018	2019
Sales	$110,000	$150,000
–COGS and Other Variable Operating Costs	- 77,000	- 105,000
–Fixed Operating Costs	- 15,000	- 15,000
EBIT	18,000	30,000
–Interest	-      0	-      0
EBT	18,000	30,000
–Taxes	- 5,400	- 9,000
Net Income	$ 12,600	$ 21,000
Red, Inc.	2018	2019
Sales	$110,000	$150,000
–COGS and Other Variable Operating Costs	- 66,000	- 90,000
-Fixed Operating Costs	- 25,000	- 25,000
EBIT	19,000	35,000
–Interest	- 5,000	- 5,000
EBT	14,000	30,000
–Taxes	- 4,200	- 9,000
Net Income	$ 9,800	$ 21,000

           Required: Calculate the operating leverage for the two firms (using 2018 sales as the base) and then compare the leverage of all types used by the two firms and discuss its impact on the firms' cost of capital.

Answer 1

There are two types of leverage which we calculate to understand the impact in a given company.

a) Operating Leverage, b) Financial Leverage.

Operating Leverage: Its the fixed operating expenses, in a given company when changed can give upside or downside impact on the operating profit of the company. It also helps us to understand the impact of the fixed cost on the company's profit.

Formula: Fixed Cost/Total Sales

Green: 15,000/110,000

= 13.63%

Red: 25,000/110,000

= 22.72%

Financial leverage: It is the impact to a company can have when it uses debt in capital. Debt is available to the company to use more capital for expansion. It also increases the cost of capital.

Formula: EBIT/EBIT - Interest

Green: 18,000/18,000-0 = 18,000/18,000

= 1

Red: 19,000/19,000-5000

19,000/14,000

= 1.357

Impact on the firms cost of capital. If the firm uses cheaper debt in capital for expansion, it can help the firm to reduce its cost of capital as the cost of debt is calculated after tax. So it gives less cost of capital and more residual income in the hands of the company. If we use higher cost of debt in capital, the company may face a problem as they will have to pay off a huge amount of money as interest.