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37.1 Leverage
Leverage increases the volatility of a companys earnings and cash flows and increases the risk of
lending to or owning a company
Valuation of a company and its equity is affected by the degree of leverage the greater the leverage,
the greater its risk and so the greater the discount rate applied
Risk associated with future earnings and cash flows of a company are affected by the companys cost
structure
Cost structure is the mix of variable and fixed costs
If a company has higher fixed operating and financing costs, it has more leverage. We can see this
effect when we plot the net income of each company against the number of units produced and sold
greater slope of line representing net income (as number of units sold changes results in greater
change in net income)
Companies with more fixed costs relative to variable costs in their cost structures have greater
variation in net income as revenues fluctuate and hence, more risk
Solution:
[6,000,000 (24,000 14,000)]
= = 1.33
[6,000,000 (24,000 14,000) 15,000,000,000]
For a 10% increase in cars sold, operating income increases by 1.33X10% = 13.33%
Industries (software developers & pharmaceutical) that tend to have high operating leverage are those
that invest upfront to produce a product but spend relatively little on making and distributing it
Solution:
At 6 million cars produced and sold, operating income = $45 billion
$45
= = 9.0
$45 $40
For every 1% change in operating income, net income changes 9% due to financial leverage