Impact of leverage in firm investment decision

Topics: Finance, Variable cost, Operating leverage Pages: 12 (2493 words) Published: October 19, 2014


2.0 What is Leverage?
Leverage can be defined as the ability of a firm to use its fixed cost assets or funds to magnify the returns to shareholders.
According to J. F. Weston, Scott, Besley and E. F. Brigham, “Leverage is created when a firm has fixed cost associated either with its sales and production operation or with its financing characteristics.”

Leverage in other sense is the degree to which an investor or business is utilizing borrowed money. The higher the degree of leverage, the higher the degree of risk and rate of return. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders’ return on their investment and often there is tax advantages associated with borrowing.

The objective of Financial Management is to maximize the wealth of organization and to magnify the returns to shareholders. Financing and investment decisions are very important in maximizing shareholder’s returns. The fixed cost assets or funds of a company play important role in maximizing EPS, ROE etc.

2.1 Classifications of Leverage:
Basically, leverages are classified into two types. But, it can be ultimately three types. These are: 1)

Operating Leverage


Financial Leverage


Total/Combined Leverage.


2.2 Operating Leverage
Operating leverage may be defined as the firm’s ability to use fixed operating cost to magnify the effects of changes in sales on its operating profit or earnings before interest and taxes (EBIT). Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs, As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets. Firm A uses a highly automated production process with robotic machines, whereas firm B assembles the widgets using primarily semiskilled labor. Table 1 shows both firms’ operating cost structures.

Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 per unit, whereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variable cost per unit is much higher at $3.00 per unit. Both firms produce and sell 10,000 widgets per year at a price of $5.00 per widget.

Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm A also has a higher breakeven point—the point at which total costs equal total sales. Nevertheless, a change of I percent in sales causes more than a I percent change in operating profits for firm A, but not for firm B. The “degree of operating leverage” measures this effect. The following simplified equation demonstrates the type of equation used to compute the degree of operating leverage, although to calculate this figure the equation would require several additional factors such as the quantity produced, variable cost per unit, and the price per unit, which are used to determine changes in profits and sales:

Operating leverage is a double-edged sword, however. If firm A’s sales decrease by I percent, its profits will decrease by more than I percent, too. Hence, the degree of operating leverage shows the responsiveness of profits to a given change in sales.


2.2.1 Degree of Operating Leverage (DOL):
The degree of operating leverage (DOL) measures the effect of a change in sales volume on earnings before interest and taxes (EBIT). It is defined as the percentage change in EBIT associated with a given percentage change in sales:


Percentage change in operating profit (EBIT)
Percentage change in sales



2.3 Financial Leverage
Financial leverage is defined as the potential use of financial costs to magnify the effects in EBIT...
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