Page 176 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 7: Concept of Leverages

Financial Leverage: It is the payment of fixed rate of interest for the use for the fixed interest Notes
bearing securities, to magnify the rate of return as equity shares.

Leverage: It allows accomplishing certain things that are otherwise not possible.
Operating Income: It is a measure of a firm’s profitability that excludes interest and income tax
expenses.
Operating Leverage: It results from the present fixed operating expenses within firm’s income
stream.

Operating Risk: It is the risk of the firm not being able to cover its fixed operating costs.
Return on Assets: This percentage shows how profitable a company’s assets are in generating
revenue.
7.7 Review Questions

1. What is meant by the term leverage? How are operating leverage, financial leverage and
total leverage related to the income statement?

2. What is operating break-even point? How do charges in fixed operating costs, the sale
price per unit and the variable operating cost per unit affect it?

3. What is operating leverage? What causes it? How is the degree of operating leverage
measured?

4. What is financial leverage? What causes it? How is the degree of financial leverage
measured?
5. What is the general relationship among operating leverage, financial leverage and the total
leverage of the firm? Do these types of leverage complement each other? Why or why not?
6. A firm has sales of 7500,000, variable cost of 42,00,000 and fixed cost of 6,00,000. It has
a debt of 45,00,000 @ 9% and equity of 55,00,000.
(a) What is the firm’s ROI?
(b) Does it have favorable financial leverage?

(c) What are the operating financial and combined leverages of the firm?
(d) If the sales drop to 500,00,000, what will be the new EBIT?
7. The capital structure of P Company consists of ordinary share capital of 10,00,000 (shares
of 100 per value) and 10,00,000 of 10% debentures. Sales increased by 20% from 100,000
to 120,000 units; the selling price is 10 per unit, variable costs amount to 6 per unit and
fixed expenses amount to 200,000. The income tax rate is 50%. You are required to
calculate the following :
(a) The percentage increase in earnings per share
(b) The degree of financial leverage at 100,000 units and 120,000 units.

(c) The degree of operating leverage of 100,000 and 120,000 units.
8. The selected financial data A, B & C Companies for the year ending 31st December, 2004
are as follows:

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