EFIN542

Corporate Finance
Dr. Atif Ghayas
Assistant Professor
Learning
Outcomes

After this Lecture, you will be able to:

• understand concept of Leverage.
• explain the concept of Operating Leverage.
• discuss Degree of Operating Leverage.
Leverage

• Refers to accomplishing certain things which are

otherwise not possible i.e. lifting of heavy objects
with the help of lever.

• Its is a tool which makes our task easier, which

produces greater output with lesser efforts.
Leverage

Effort Load

Fulcrum
Leverage in Finance

The employment of an asset or source of funds

for which the firm has to pay a fixed cost or
fixed return may be termed as leverage.
Leverage

Leverage is a strategy that companies use to

increase assets, cash flows, and returns, though it
can also magnify losses.
Leverage

There are two main types of leverage:

Based on Cost Structure: Operating Leverage

Capital Structure: Financial Leverage

Types of Leverage

Leverage

Operating Financial Combined

Leverage Leverage Leverage
Types of Leverage

Operating leverage:

• Relationship between the firm’s sales revenues and its

EBIT.

Financial leverage:

• Relationship between the firm’s earnings available for

ordinary shareholders and its EBIT.
Operating Leverage

The operating costs of a firm fall into Two categories:

i. Fixed costs: Which do not vary with sales volume.

ii.Variable costs: which vary directly with the sales

volume.

High Fixed Cost = High Operating Leverage

Operating Leverage

HIGH OPERATING LEVERAGE COMPANY

AIRLINES

Fixed Costs:

• Aircrafts, Hangars, Insurance

Variable Costs:

• Jet Fuel, Runway Charges

Operating Leverage

LOW OPERATING LEVERAGE COMPANY

CONSULTING

Fixed Costs:

• Rent, Utilities

Variable Costs:

• Salaries
Effect of Operating Leverage

• Change in the volume of sales results in a more than

proportional change in operating profit.

• A company with higher leverage generates bigger

profits when sales goes up because fixed costs remain
the same as revenues increase.

• A company with higher operating leverage will

experience bigger losses when sales drop.

• Operating Leverage affects Firm’s business risk.

Example

• Firm ABC sells products for Rs 100 per unit

• It has variable operating costs of Rs 50 per unit and

fixed operating costs of Rs 50,000 per year.

• Calculate EBIT from the sale of:

i. 1,000 units

ii. 2,000 units

iii. 3,000 units.

Example

Case 2 Base Case 1

(-50%) (+50%)
Sales (Units) 1,000 2,000 3,000
Sales Revenue 1,00,000 200,000 3,00,000
Less: Variable Operating Cost 50,000 1,00,000 150,000
Contribution 50,000 1,00,000 150,000
Less: Fixed operating cost 50,000 50,000 50,000
EBIT 0 50,000 1,00,000
-100% +100%
Degree of Operating Leverage (DOL)

• The percentage change in a firm’s operating profit

(EBIT) resulting from a 1 per cent change in output
(sales).
Degree of Operating Leverage (DOL)

Also,

Contribution = EBIT + Fixed Cost

Example

Firm X’s
1. Sales = 200
2. Variable cost = 40
3. Fixed Cost = 80

Calculate Degree of Operating Leverage if sales:

4. Increases by 20% in year 2.
5. Decreases by 20% in year 2.
Example

Increases by 20% in year 2

Year 1 Year 2 Change %

Sales 200 240 20%
Variable Cost 40 48 20%
Contribution 160 192 20%
Fixed Cost 80 80 0%
EBIT 80 112 40%
Example

% Change in EBIT
DOL =
% Change in Sales

40%
=
20%

= 2
Example

• Decreases by 20% in year 2

Year 1 Year 2 Change %

Sales 200 160 -20%
Variable Cost 40 32 -20%
Contribution 160 128 -20%
Fixed Cost 80 80 0%
EBIT 80 48 -40%
Example

% Change in EBIT
DOL =
% Change in Sales

-40%
=
-20%

= 2
Significance of Operating Leverage

• Helps evaluate how sensitive its operating income is

with respect to changes in Sales.
• Analyst should fully understand a company’s cost
structure, fixed costs, variable costs and its operating
leverage.
Conclusion

• Leverage is a two edged sword.

• On one hand it magnifies the profit of the firm while
on the other hand, can also increase the potential for
loss.
• Type of industry and the state of the economy are
two very important factors to be considered.
Summary

• Concept of leverage.

• Concept of Operating Leverage.

• Calculated Degree of operating leverage.

That’s all for now…