Ch 4

Question 1

What is leverage in business?

Answer 1

Leverage uses fixed costs to magnify the potential return to a firm.

Types of Fixed Costs:
Operating: e.g., rent, amortization
Financial: e.g., interest from debt

Question 2

What is operating leverage and its formula?

Answer 2

Operating Leverage measures how much fixed operating costs are used by a firm.
Formula:
DOL
=ContributionMargin/EBIT

DOL > 1 means a small change in sales results in a large change in EBIT.

Question 3

What is financial leverage and its formula?

Answer 3

Financial Leverage measures how much debt is used in a firm’s capital structure.
Formula:
DFL
=% ChangeinEPS/%ChangeinEBIT

DFL > 1 means a small change in EBIT causes a large change in EPS.

Question 4

What is the break-even point and how do you calculate it?

Answer 4

Break-Even Point (BE): The sales level at which total revenue equals total cost.
Formula:
BE
=FixedCosts/ContributionMargin

​Fixed Costs: Stay constant in the short term.
Variable Costs: Change with production or sales.

Question 5

What is the risk of leverage in a business?

Answer 5

Leveraged Firm:
High fixed costs
High break-even point
High DOL
Amplifies both profits and losses
Non-Leveraged Firm:
Low fixed costs
Low break-even point
Low DOL

Question 6

What is the indifference point in leverage?

Answer 6

The level of EBIT at which different financing options result in the same EPS.
Formula:
EBIT∗=(𝑆𝐵×𝐼𝐴−𝑆𝐴×𝐼𝐵)/𝑆𝐵-𝑆𝐴

Question 7

What is combined leverage and its formula?

Answer 7

Combined Leverage measures the total effect of both operating and financial leverage.
Degree of Combined Leverage (DCL):
DCL=DOL×DFL

DCL > 1 means a small change in sales causes a larger change in EPS.

Question 8

What are the types of costs in break-even analysis?

Answer 8

Fixed Costs: Constant in the short term (e.g., rent, salaries).
Variable Costs: Change with production/sales (e.g., raw materials, labor).
Semi-variable Costs: Change, but not directly tied to production (e.g., utilities, maintenance).