Leverage
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The document discusses three types of leverage: operating leverage, financial leverage, and total leverage. Operating leverage measures the effect of changes in sales on earnings before interest and taxes (EBIT). Financial leverage measures the effect of changes in EBIT on earnings per share (EPS). Total leverage is the combination of operating and financial leverage and measures the impact of changes in output/sales on EPS. Each type of leverage is a measure of risk to the firm from changes in sales, EBIT, or output.
![Financial Leverage Measures effect of change in EBIT on EPS Also refers to mix of debt and equity in capital structure of the firm. Double edged sword. DFL = (% change in EPS)/(% change in EBIT) Or DFL= EBIT/ {EBIT-I- [Pref Div/(1-t)]}](https://image.slidesharecdn.com/leverage-100925115157-phpapp01/85/Leverage-7-320.jpg)
Leverage
- 2. Capital Structure Various means of financing represent financial structure of the firm. It includes liabilities + equity Traditionally short term borrowings are excluded from the list of methods of financing capital exp. and hence all long term claims are a part of capital structure.
- 3. Types of Leverage Three types Operating Leverage. Financial Leverage. Combined Leverage
- 4. Operating Leverage Effect of change in sales on EBIT of the company DOL indicates – small change in level of sales will produce large change in Operating income It’s a measure of firms business risk- variability in EBIT DOL=( % change in EBIT)/ (% change in sales or output) or {Q(S-V)}/ {Q(S-V)-F)
- 5. Operating Leverage Contd.. DOL at Operating break even point, where EBIT is zero is undefined. Units at Break even point can be cal. Using formula Q= Total Fixed cost/(S-V)p.u Different levels of output has different DOLs It’s a measure of Firms business risk
- 7. Financial Leverage Measures effect of change in EBIT on EPS Also refers to mix of debt and equity in capital structure of the firm. Double edged sword. DFL = (% change in EPS)/(% change in EBIT) Or DFL= EBIT/ {EBIT-I- [Pref Div/(1-t)]}
- 8. Financial Leverage Contd… DFL is undefined at Financial Break Even point. EBIT= I+{Pref Div./(1-t)} gives us the point of Fin Break Even point. EPS is zero at Fin Break Even point Each level of EBIT has different DFL It indicates the financial risk of the firm.
- 9. Total Leverage Combination of DOL & DFL. It’s a measure of impact in change in output/sales on the EPS of the company DTL=% change in EPS/ % change in output. Or DTL= Q(s-v)/(Q(s-v)-F-I-{Pref Div/(i-t)}) Measure of Total Risk