Capital Structure: Part 2_M2

Question 1

What is Operating Leverage?

Answer 1

Operating leverage =
Q(S − VC)
Q(S − VC) − FC

where:
Q = Quantity
FC = Fixed cost
VC = Variable cost
S = Selling price

Question 2

What is HIGH operating leverage?

Answer 2

• High operating leverage = high FC=more profitability than firms with high VC.
• Has the risk of covering fixed costs regardless of sales.
• Once fixed costs are recovered, the additional contribution margin goes to operating income.

Question 3

What is LOW operating leverage?

Answer 3

• Low operating leverage = high VC = less profit.
• Less risk and less potential return are consistent with a company that has low operating leverage, implying low fixed costs and relatively higher variable costs.
• A firm that has low operating leverage will need more additional sales to increase profits than a company with high operating leverage.

Question 4

What is financial leverage?

Answer 4

• The use of debt to finance operations.
• The effects of percentage change in earnings before interest and taxes (EBIT) on the percentage change in its EPS.
• When issuing debt, the company must produce sufficient EBIT to cover its fixed interest costs.
• Once fixed interest costs are covered, additional EBIT will go directly to net income and EPS.
• higher percentage of fixed financing cost.
• It is a function of decisions made by management.
• Decisions are often the result of industry characteristics.

Question 5

What is Financial Leverage?

Answer 5

Financial leverage =
EBIT /
EBIT − I − [P ÷ (1 − t)]

where:
I = Interest expense
P = Preferred dividends
t = Tax rate
EBIT = Earnings before interest and taxes

EBIT= Sales - VC - FC Sale = QTY x Price,VC= QTY x VC Price, FC=Given

Question 6

What is Total Leverage?

Answer 6

Total leverage =
Q(S − VC) /
Q(S − VC) − FC − I − [P ÷ (1 − t)]

where:
Q = Quantity
FC = Fixed cost
VC = Variable cost
S = Selling price
I = Interest expense
P = Preferred dividends
t = Tax rate

Question 7

How to analyze the debt ratio?

liabilities/assets

Answer 7

• is a measure of a company’s solvency (ability to meet long-term obligations).
• The lower the ratio is, the lower the risk from the perspective of a creditor.
• The lowest debt ratio, the least risky from the perspective of creditors.