Q #01: Following data is related to company A and B. Company A Company B EBIT 50,000 62,000 Fixed Cost 10,000 33,000 Variable Cost 20,000 12,000 Interest Cost 7,000 15,000 Preferred Dividends 5,000 8,000 Tax rate 30% 30% A) What is degree of operating leverage and degree of financial leverage for both firms. Interpret your answer also. B) What will be degree of total leverage for both firms? Interpret your answer.

Answer:

There are two basis type of leverage 1) Operating leverage and 2.) Financial leverage and there is another one called total leverage or combine leverage.

1.) Operating leverage: It shows how much effect on profit before interest and tax (PBIT) on change on in sales. It arises because of fixed in firm.

The formula is,

DOL (degree of operating leverage) = % change in PBIT / % change in sales

Another formula is,

DOL = Contribution / PBIT

Here contribution = Sales - Variable cost

So DOL of company A is,

Sales = EBIT + Fixed cost + variable cost

= 50,000 + 10,000 + 20,000

= 80,000

Contribution = Sales - Variable

= 80,000 - 20,000

= 60,000

DOL = Contribution / PBIT

= 60,000 / 50,000

= 1.2

It means that if there is 1% down in sales then PBIT will be down by 1.2% vice- versa.

Now DOL for Company B

Sales = EBIT + Fixed cost + variable cost
= 62,000 + 33,000 + 12,000

= 107,000

Contribution = Sales - Variable cost

= 107,000 - 12,000

= 95,000

DOL = Contribution / PBIT

= 95,000 / 62,000

= 1.53

It means that if there is 1% down in sales then PBIT will be down by 1.53% vice- versa.

Now financial leverage, it shows how much PBT (Profit before Tax) will change by change in PBIT. It arises because of fixed interest cost.

Formula,

DFL (degree of financial leverage) = % change in PBT / % change in PBIT

Another formula,

DFL = PBIT / PBT

Now for company A

EBIT or PBIT = 50,000

PBT or EBT = PBIT - Interest cost

= 50,000 - 7,000

= 43,000

DFL = PBIT / PBT

= 50,000 / 43,000

=1.16

It means that if PBIT change by 1% then PBT will b=change by 1.16%.

Now for company B

PBT = 62,000 - 15,000

= 47,000

DFL = PBIT / PBT

= 62,000 / 47,000

= 1.32

It means that if PBIT change by 1% then PBT will b=change by 1.32%..

So from the operating leverage and financial leverage we can see that Company B is highly leverage in terms of fixed cost and finance cost compare to Company A.

B.) Total leverage or combine leverage, its show how much profit before (PBT) is change by change in sales. Its arises because of both fixed cost and interest cost.

Formula is,

DTL (degree total leverage) = % change in PBT / % change in sales

Another formula is,

DTL = Contribution / PBT

So for company A

DTL = Contribution / PBT

= 60,000 / 43,000

= 1.40

It means that if sales change by 1% then PBT will change by 1.4%.

Now for company B

DTL = Contribution / PBT

= 95,000 / 47,000

= 2.02

It means that if sales change by 1% then PBT will change by 2.02%.

We can find total leverage by multiply DOL * DFL = DTL

For company A

DTL = DOL * DFL

= 1.2 * 1.16

=1.392

And for company B

DTL = DOL * DFL

= 1.53 * 1.32

= 2.02

So we can see that company B is high leverage company compare to company A. If sales of Companies increases then profit of Company B will increase more compare to company A but if sales decreases of companies then profit loss will be more in case of company B compare to company A.