Leverage Notes

In: Business and Management

Submitted By devrishivijan
Words 829
Pages 4
LEVERAGE ANALYSIS

Leverage arises from the presence of fixed costs in a firm’s cost structure. Two types of leveragea) Operating Leverage and b) Financial Leverage. •Operating leverage arises from fixed operating costs (depreciation, salaries, advertisement etc).
•Financial leverage from the presence of fixed financing costs such as interest.

Concepts that enhance our understanding of risk...
1) Operating Leverage - affects a firm’s business risk.

2) Financial Leverage - affects a firm’s financial risk.

Operating Leverage
The use of fixed operating costs as opposed to variable operating costs. A firm with relatively high fixed operating costs will experience more variable operating income if sales change. So it is the responsiveness of the firm’s EBIT to fluctuations in sales.

Costs
• Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

Total Revenue

Rs

}EBIT

Total Cost

+

Breakeven point

Q1

Quantity

{

-

FC

Operating Leverage
• What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

Total Revenue

Rs

+
FC

}
Q1

EBIT
Total Cost = Fixed

{

New Breakeven Point with FC

Old Breakeven Point with VC &FC

Quantity

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.
Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Breakeven Calculations
Breakeven point (units of output): BEP (Q) = F/(P – V)  F = total anticipated fixed costs.  P = sales price per unit.  V = variable cost per unit.
Breakeven point (sales rupees):

BEP (sales revenue) = F/(1- (VC/S))
 F…...

Similar Documents

Leverage

...ASSIGNMENT #1 [pic] ASSIGNMENT #2 [pic] ASSIGNMENT #3 In terms of leverage, the Chinatrust is less risky than Metropolitan banks as evidenced by its higher Equity/Assets ratio and Equity/consumer Loans. As to liquidity, MetMetropolitan, on the other hand is more liquid since 45% of its total assets are earning assets as compared to Chinatrust’s 32%. ASSIGNMENT #4 Ayala Corporation has five industry segments where the Group operates: the Parent, Real Estate, Electronics, International and Automotives&Others. The parent company accounted for 20% of the consolidated revenues and 70% of the consolidated income. With very low opex, the Parent generates the highest operating profit at 90% and Net Profit margin of 70%. It is also the most efficient with the highest ROA among the segments. Real Estate segment contributed 30% of the consolidated income with an ROE of 10% and Net Profit Margin of 20%. The Electronics segment’s ROE and Net Profit Margin was almost zero despite its high revenues due to its large cost of opex. Electronics has many non-cash expenses, aside from the heavy depreciation which means it might have a good cash flow despite the very low Net Income. The Parent with 50% of the total assets financed by borrowings and Debt-Equity ratio of 1 is considered to be the most risky. On the other hand, the Automobile is the least risky with almost zero Debt/Asset and Debt/Equity Ratio. Ayala also presented its business segments on a......

Words: 516 - Pages: 3

Leverage and Firm Risk

...management in the other. Operating Leverage Business risk depends in part on the extent to which a firm builds fixed costs into its operations. If fixed costs are high, even a small change in sales can result in a large change in EBIT. The measure of a firm's operating risk is called operating leverage. If a high percentage of a firm's operating costs is fixed, the firm will have a high degree of operating leverage. As a result, a small change in sales will result in a large change in EBIT. Operating leverage is defined as the ratio of the percentage change in operating earnings (EBIT) to the percentage change in sales. If Δ represents the change in a variable, S represents total sales, VC represents total variable costs, and FC represents total fixed costs, the degree of operating leverage (DOL) at a particular level of sales is given by: [pic] (1) [pic] [pic] (1') where v = VC/S is the fraction variable costs are of sales. This equation is easily derived since EBIT = S-VC-FC. Conceptually operating leverage is best understood and interpreted using equation (1). However, when calculating DOL, equation (1') is easier to use since it requires only one year of data and requires only one calculation—dividing contribution by EBIT. (The specific form of Equation (1') does assume that unit prices and variable costs are constant as sales change, however.) As an example of operating leverage, at a sales level......

Words: 4423 - Pages: 18

Leverage Problem

...CHAPTER 20 Leverage 397 Problems 1. Firm A has $10,000 in assets entirely financed with equity. Firm B also has $10,000 in assets, but these assets are financed by $5,000 in debt (with a 10 percent rate of interest) and $5,000 in equity. Both firms sell 10,000 units of output at $2.50 per unit. The variable costs of production are $1, and fixed production costs are $12,000. (To ease the calculation, assume no income tax.) Firm A Assets $10,000 Firm B Assets $10,000 $5,000 in Debt @ 10% $5000 in equity Both Sell 10,000 units @ 2.50 Variable cost $1 Fixed Cost $12,000 a. What is the operating income (EBIT) for both firms? Firm A EBIT = Revenue - Operating Expenses = $2.50*10,000 - $1*10000 - $12,000 = $3,000 Firm B EBIT = Revenue - Operating Expenses = $2.50*10,000 - $1*10000 - $12,000 = $3,000 b. What are the earnings after interest? Earnings After Interest Firm A $3,000 - $0 = $3,000 Firm B $3,000 - 10% * $5,000 = $3,000 - $500 = $2,500 c. If sales increase by 10 percent to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the question, determine the earnings after taxes and compute the percentage increase in these earnings from the answers you derived in part b. New Sales = 11000 Firm A EBIT = Revenue - Operating Expenses = $2.50*11,000 - $1*11000 - $12,000 = $4,500 So Earning After Interest = $4,500 %Increase = ($4,500 - $3,000)/$3,000 = 50% ...

Words: 357 - Pages: 2

A Leverage Buyout

...Running head: A LEVERAGE BUYOUT 1 Graves Dancer Takes Tribune Corporation private in an Ill-Fated Transacti A LEVERAGE BUYOUT 2 Introduction A leverage buyout (LBO) is a kind of acquisition where the buying price is financed via debt and equity. The cash flow or assets of the target company are used to secure the debt and repay it. The returns on equity increase as the debt increase as debt has a lower cost of capital compared to equity. In other word a LBO is a method of acquiring a company with money that is nearly all borrowed. To conduct an LBO, the acquirer ensures that the target’s assets are adequate as collateral for the loan needed to purchase the target. The acquirer must also create and study financial forecasts of the combined entities to make sure that they generate enough cash to cover the principle and interest payments. Once the buyer has determined that the LBO is financially feasible it works on acquiring enough cash for the acquisition by incurring debt. Doing an LBO is expensive and the process can be complex. LBO’s are popular in merger and acquisition as the acquiring organization uses money borrowed to fund the acquisition. The assets of the target organization are used as collateral to get the loan. LBO enables organization to make a big acquisition without using a lot of capital. Purpose of the paper This paper seeks to analyze the acquisition of Tribune Corporation by Grave Dancer. The......

Words: 1623 - Pages: 7

Leverage Buyout

...using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital. | | In an LBO, there is usually a ratio of 90% debt to 10% equity. Because of this high debt/equity ratio, the bonds usually are not investment grade and are referred to as junk bonds. Leveraged buyouts have had a notorious history, especially in the 1980s when several prominent buyouts led to the eventual bankruptcy of the acquired companies. This was mainly due to the fact that the leverage ratio was nearly 100% and the interest payments were so large that the company's operating cash flows were unable to meet the obligation. One of the largest LBOs on record was the acquisition of HCA Inc. in 2006 by Kohlberg Kravis Roberts & Co. (KKR), Bain & Co., and Merrill Lynch. The three companies paid around $33 billion for the acquisition. It can be considered ironic that a company's success (in the form of assets on the balance sheet) can be used against it as collateral by a hostile company that acquires it. For this reason, some regard LBOs as an especially ruthless, predatory tactic. | 2. When you decide the capital structure of a firm, what factors you should consider?? Capital Structure is referred to......

Words: 1303 - Pages: 6

Operating Leverage

... OPERATING LEVERAGE: Operating leverage can be risky. When does an organization benefit from having a high degree of operating leverage? When does it lose from having a high degree of operating leverage? First, operating leverage arises from fixed costs in organizations structure. As the proportion of fixed costs to contribution margin rise, the operating leverage rises. Some industries may be forced to have a high degree of operating leverage because the nature of their business requires high fixed costs. These include; airlines, newspapers, pharmaceuticals, and utilities. Some industries can make choices about their leverage, either by outsourcing fixed cost components (paying another company to provide the service/equipment) or by choosing between labor (variable cost wages) or machines (fixed costs). The Healthcare industry is not considered a high leverage industry yet, but I am sure that the leverage is increasing with more advanced equipment. Sales do not affect the degree of leverage, but the nature of the sales may determine how much leverage should be used. If sales are relatively stable, the organization can utilize a higher degree of leverage. If sales fluctuate or are otherwise unstable, the organization should try to maintain a lower degree of leverage. How? A simply way is too use variable hourly labor instead of automated fixed equipment. Be careful that you don’t get confused by variable costs. Variable costs, as it pertains to operating leverage, are those......

Words: 837 - Pages: 4

Leverage Buyouts

...Lindsey Bembry Leveraged Buyouts A leveraged buyout, LBO, is an acquisition of a company or a portion of a company with a considerable portion of loaned funds. The assets of the target company are used as collateral. Each leveraged buyout is unique in that companies have their own capital structure. The one characteristic that is common within each LBO is the use of financial leverage to complete the purchase of the target company. In order for a LBO to take place, an investor, private equity firms or financial sponsor is needed. In a typical LBO, the firm obtaining the company will finance the purchase with a mixture of debt and equity. A segment of the debt in a LBO is protected by the assets of the target company. New cash flows from the bought out business are then used to pay the debt from the buyout. Leveraged buyouts happen to companies of all sizes and in all different types of industries. However, some elements from possible target firms include; small debt loads, history of positive cash flows, a significant amount of tangible assets, the possibility of new management making improvements, and for valuation/stock price to be minimal. Debt financing is borrowing money from a source with the intent to pay back the principal plus an agreed upon interest. An advantage of debt financing is those who use it can maintain ownership. Corporate balance sheets typically use principal and interest payments as a business expense which can be deducted from......

Words: 1109 - Pages: 5

Operating Leverage

...Discussion Week 3: Read Exercise 4-1 (Note: This is will not be done as a group assignment). Answer end of exercise question and post answer in discussion board. Operating Leverage: John Diaz owns Pacific Electric, a large electrical contracting firm that provides services to building construction projects. The company has 2,000 employees and operates in three western states. Recently the company experienced large losses due to a downturn in the economy and a slowdown in construction. John thinks the losses were particularly large because his company has too much fixed cost. Required: a. Expand on John’s thought. How are the large losses related to fixed costs? In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. In John’s case, I will assume that he will have a Cost-Volume-Profit Analysis performed. I would hope also that this analysis would be performed on each of his businesses in the three states that he operates within and at a corporate level. No company should go on gut feelings when it comes to saving their business and this could be the situation for John. Cost-Volume-profit (CVP), in managerial economics is a form of cost accounting. It is a simplified model, useful for elementary instruction and for short-run decisions. Cost-volume-profit (CVP) analysis expands the use of......

Words: 772 - Pages: 4

Financial Leverage

...in the use of financial leverage for a utility company and an automobile | | |company? | | | | | |A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an | | |automobile company, which is generally subject to the influences of the business cycle. An automobile | | |manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. | | | | |5-3. |Explain how the break-even point and operating leverage are affected by the choice of manufacturing facilities | | |(labor intensive versus capital intensive). | | | | | |A labor-intensive company will have low fixed costs and a correspondingly low break-even point. However, the | | |impact of operating leverage on the firm is small and...

Words: 7868 - Pages: 32

Optimal Leverage Ratio

...Joyce Corporation Limited (JYC). Those firms are rated by their market value of share capital. JBH and MYR both have market capital over $1 billion which are at the top of this industry. KMD and TRS are from the middle section which have market capital about $0.6 billion and $0.25 billion. The two bottom companies SNL and JYC are with $78 million and $14 million market capital respectively. This report, will firstly explain why do we use D/E ratio as a firm leverage, followed by comparing the advantages and disadvantages via debt financing, detail analysis of each company are included. Then, the report clarifies how we make assumptions and calculate the “optimal leverage”. Finally, the pathway each company could achieve its optimal is given. * Reasons to Choose D/E as Firm Leverage The debt-equity ratio we use is calculated by dividing Net Debt by Market Value of Equity. Net debt is the total debt minus cash. It is used to achieve a more relevant measure of leverage because the cash could reduce the risk of leverage. Market value of equity is considered in this ratio as it is more informative than the book value. The chart below is the debt-equity ratio of the six companies along with the industrial average ratio. As it is shown in the chart, the debt-equity ratio of all six companies are varied. JBH maintain a stable level around 0.12 and then experienced a sudden drop in 2013 and 2014, which is mainly due to a strong increase in share price of JBH and a......

Words: 3497 - Pages: 14

Leverage

...Table of contents Contents i. Introduction to Leverage 3 ii. Significance of the Issue 3 iii. What is Leverage? 4 iv. Kinds of Leverage 4 a) Financial Leverage. 4 b) Operating Leverage. 4 c) Combined Leverage 5 v. Risks of Leverage 5 vi. Conclusion 5 vii. List of references 6   i. Introduction to Leverage In finance, Leverage is considered to be any financial instrument or loaned capital used to increase the potential return of an investment. Leverage is usually used in real estate and often in the automobile industry in the form of mortgage to purchase houses or vehicles. Leverage aids both the shareholder and the firm, but it comes with great deal of risk. If an investor makes use of leverage to create an investment and it doesn’t go in his or her favor, their loss is much larger than it would've been if they hadn’t used leverage. Leverage amplifies both gains and losses. In the business world, a firm is able to make use of leverage to try to produce shareholder wealth, but if it is unsuccessful to do so, the interest expense and credit risk of damaging the shareholder's value. Leverage can be used in many branches of finance including bonds, stocks, currencies, commodities and also other investments. Leverage can either be a good or bad thing for the firm depending on the situations that arise. ii. Significance of the Issue Leverage is one of the main topics in finance, one cannot study finance without coming across words like investments, loans,......

Words: 929 - Pages: 4

Leverage Case

...Title: Financial Leverage Practice of Indian Communications Ltd.: Bane or boon Indian Communications Ltd. had been a zero debt company since start. Of late, shareholders of the company were pressurizing to include debt in the capital structure as shareholders competitor company were getting a higher yield on account of financial leverage. The shareholders’ movement from Indian Communications has resulted in decline in the market price of the company. The board of the company was under a dilemma- should they go for debt not? If they went for debt, it might be risky, and if they did not would- shareholders would withdraw. In both the cases, it would affect the company’s survival. INDIAN COMMUNICATIONS LTD. Indian Communications Ltd was a telecommunication company headquartered in Mumbai, India. It was a leading player in next generation, integrated (wireless and wire line), and digital network, covering over 20,000 cities and towns and over 2, 00,000 villages . It had business operations in more than 20 countries. With US $ 10bn revenues in FY 14 it had been a great last year. It was India's truly integrated telecommunication service provider. The company had a Customer base of around 100 million including over 2 million individual overseas retail customers and corporate clientage over 30,000 Indian and multinational corporations. . Two friends started it in 1997 with just US$ 1000. From the beginning, the company had followed a conservative......

Words: 1709 - Pages: 7

Strategy as Stretch and Leverage

...Stretch and Leverage 06/05/2016 14:29 INNOVATION Strategy as Stretch and Leverage by Gary Hamel and C.K. Prahalad FROM THE MARCH–APRIL 1993 ISSUE G eneral Motors versus Toyota. CBS versus CNN. Pan Am versus British Airways. RCA versus Sony. Suppose you had been asked, 10 or 20 years ago, to choose the victor in each of these battles. Where would you have placed your bets? With hindsight, the choice is easy. But at the time, GM, CBS, Pan Am, and RCA all had stronger reputations, deeper pockets, greater technological riches, bigger market shares, and more powerful distribution channels. Only a dreamer could have predicted that each would be displaced by a competitor with far fewer resources—but far greater aspirations. Driven by the need to understand the dynamics of battles like these, we have turned competitiveness into a growth industry. Companies and industries have been analyzed in mind-numbing detail, autopsies performed, and verdicts rendered. Yet when it comes to understanding where competitiveness comes from and where it goes, we are like doctors who have diagnosed a problem—and have even found ways to treat some of its symptoms —but who still don’t know how to keep people from getting sick in the first place. We can analyze companies in mindnumbing detail, perform autopsies, and render verdicts, but we are still addressing http://hbr.org/1993/03/strategy-as-stretch-and-leverage Page 1 of 24 Strategy as Stretch and......

Words: 7792 - Pages: 32

Leverage Buyout

...Leverage Buyout A leveraged buyout (LBO) occurs when an investor, typically a financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage (borrowing). The assets of the acquired company are used as collateral for the borrowed capital, sometimes with assets of the acquiring company. Typically, leveraged buyout uses a combination of various debt instruments from bank and debt capital markets. The bonds or other paper issued for leveraged buyouts are commonly considered not to be investment grade because of the significant risks involved. Management buyouts (MBO) are similar in all major legal aspects to any other acquisition of a company. The particular nature of the MBO lies in the position of the buyers as managers of the company, and the practical consequences that follow from that. In particular, the due diligence process is likely to be limited as the buyers already have full knowledge of the company available to them. The seller is also unlikely to give any but the most basic warranties to the management, on the basis that the management knows more about the company than the sellers do and therefore the sellers should not have to warrant the state of the company. Aside from debt financing, one of the principal features of the leverage buyout is the ability to unlock value in an undervalued company. The corporate raiders of the 1980's were famous, if not notorious,......

Words: 1080 - Pages: 5

Etf Leverage

...mix are leveraged and inverse exchange-traded funds ETFs. Lately, these products have been the subject of much attention and have attracted considerable assets. Where traditional ETFs attempt to replicate the performance of a stock market index, leverage and inverse ETFs aim to achieve 2x or 3x long exposure, or -1x, -2x, or -3x short exposure. This, and the accessibility of ETFs, creates a vast number of opportunities for investors of all levels. As with all investment vehicles, however, these ETFs are coupled with a large amount of risk. The structure of these funds also creates a number of unintended consequences on the markets and often leads to questions regarding investor suitability. Since being introduced to the market in 2006, this ETF class has exploded with activity. According to “The Dynamics of Leveraged and Inverse Exchange-Traded Funds” by Minder Cheng and Ananth Madhavan, as of January 2009, 106 leveraged and inverse ETFs have been introduced in the U.S. market alone. The majority, however, of the $22 billion of assets under management , is in 2x and -2x leveraged products, with only a small percentage of the assets under management allocated to the greater leveraged and inverse ETFs. Traditional ETF vs. ETF Leverage: The difference between traditional ETFs and leveraged and inverse ETFs goes further than just their exposure to returns. The construction of these investment vehicles also is different. Regarding traditional ETFs, authorized participants......

Words: 640 - Pages: 3