Leverage
This document defines and explains different types of leverage used in business including operating, financial, and combined leverage. It discusses leverage as the use of fixed costs or financing to magnify the effects of changes in sales or earnings. Operating leverage is defined as how revenue growth impacts operating income due to fixed operating expenses. Financial leverage magnifies the effect of changes in earnings before interest and taxes (EBIT) on earnings per share through the use of fixed financial charges. Combined leverage is the combined effect of operating and financial leverage. The document also discusses degree of operating leverage (DOL) and degree of financial leverage (DFL) as quantitative measures and compares the effects of leverage in EBIT-EPS analysis.
-D℗/N
ΔEPS = [ΔQ(S-V)](1-T)/N](https://image.slidesharecdn.com/rohitraina-0613mba13-finance-leverage-140906092623-phpapp01/85/Leverage-10-320.jpg)
Leverage
- 1. LEVERAGE Submitted By : Rohit Raina 0613-MBA-2013
- 2. LEVERAGE Leverage is the employment of an asset/source of finance for which firm pays fixed cost/fixed return.
- 3. Type of Risks Business Risk Financial Risk
- 4. TYPES 1. OPERATING LEVERAGE. 2. FINANCIAL LEVERAGE. 3. COMBINED LEVERAGE.
- 5. OPERATING LEVERAGE It is a measure of how revenue growth translate into growth in operating income. operating leverage arises because of the use of fixed operating expenses in a firm. Operating leverage = Contribution/Operating profit.
- 6. OPERATING COST 1. FIXED COST. 2. VARIABLE COST. 3. SEMI-VARIABLE COST.
- 7. Fixed Cost 1. FIXED COST:-It is defined as those cost which do not vary with sales volume, they are a function of time and are typically contractual. 2. VARIABLE COST:-It is defined as those cost which vary directly with the sales volume. 3. SEMI-VARIABLE COST:-It is defined as those cost which are partly fixed and partly variable.
- 8. OPERATING LEVERAGE IN TERMS OF DOL The DOL measure in quantitative terms the extent or degree of operating leverage. DOL = ΔEBIT÷EBIT/ΔQ÷Q EBIT = Q(S-V)-F , ΔEBIT = ΔQ(S-V) Q = Sales quantity in units. S = Selling price per unit. V= Variable cost per unit. F = Total fixed cost.
- 9. FINANCIAL LEVERAGE It is defined as the ability of a firm to use fixed financial charges to magnify the effect of change in EBIT on the earning per share. It is also called as trading on equity.
- 10. FINANCIAL LEVERAGE IN TERM OF DFL Financial leverage can be more precisely expressed in terms of the degree of financial leverage. DFL = ΔEPS÷EPS/ΔEBIT÷EBIT EPS = [Q(S-V)-F-I](1-T)-D℗/N ΔEPS = [ΔQ(S-V)](1-T)/N
- 11. COMBINED LEVERAGE It is a combination of both operating leverage and financial leverage. Combined leverage =ΔEPS-EPS/ΔQ-Q
- 12. EBIT – EPS ANALYSIS The EBIT – EPS analysis as a method to study the effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT.A firm has choice to raise funds for financing its investment proposals from different sources in different proportions.
- 13. ADVANTAGES 1. It allow trader to increase their exposure to particular positions. 2. Leverage allow investors to offset capital losses from other trading activities. 3. It is helpful in generating greater profits. 4. It is helpful to reduce overall risk exposure.
- 14. DISADVANTAGES 1. The main drawback of leverage is its potential to scale up losses when the going gets tough. 2. Leverage is used only as a part of your trading strategy and does not form the sole backbone of your trading strategy. 3. Leveraged positions can lead to a total wipe out of your trading balance and over the years many traders have found themselves falling victim to the negatives effects of leverage.