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In Finance, leverage is defined as a firms use of assets and liabilities having fixed costs in an attempt to increase potential returns to stockholders.
Important
components of a firms business risk and financial risk by a firm in the hope of earning returns in excess of the fixed costs of its assets and liabilities, thereby increasing the returns to common stockholders
Used
Over the short run, certain operating costs within a firm vary directly with the level of sales whereas other costs remain constant, regardless of changes in the sales level.
Costs that move in close relationship to changes in sales Tied to the no. of units produced and sold Raw materials, Direct Labor costs, Sales Commissions
Primarily related to the passage of time Independent of sales or output levels Depreciation on PPE; Rent; Property Taxes
Costs that increase in a stepwise manner as output increase Income Taxes, Utility Costs
FULCRUM Multiplier Effect resulting from the firms use of fixed operating costs
DOL @ X =
(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes $5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000
300,000
450,000 150,000 300,000
380,000
570,000 150,000 420,000
$3
$4.2
Each 1% change in sales from the base sales level of $5 million results in a 2% change in EBIT in the same direction as the sales change.
(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes $5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000
300,000
450,000 150,000 300,000
380,000
570,000 150,000 420,000
$3
$4.2
DOL is the measurement of the relationship of a companys contribution margin to income from operations. Fixed Operating Cost
DOL
DOL @ X =
(1) Sales Variable Costs (60% of Sales) Fixed Operating Costs Total Operating Costs EBIT Interest Payments Earning Before Taxes Income Taxes ( Variable, 40%) Earnings After Tax Preferred Dividends
Earnings to Common shareholders Earnings/ SH 100,000 shares
(2) $ 5,500,000 3,300,000 1,000,000 4,300,000 1,200,000 250,000 950,000 380,000 570,000 150,000 420,000 $4.2
$5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000 300,000 450,000 150,000 300,000 $3
DFL @ $1,000,000 = 40% / 20% = 2.0 A DFL of 2.0 means that each 1% change in EBIT from a base of $1 million results in a 2% change in EPS in the same direction as the EBIT change.
DFL @ X =
$5,000,000 3,000,000 1,000,000 4,000,000 1,000,000 250,000 750,000 300,000 450,000 150,000 300,000 $3
EBIT
=
380,000 570,000 150,000 420,000 $4.2
$ 1,000,000 $500,000
= 2.0