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MBA II SEMESTER
Objectives
The fundamental concept and rationale of leverage in
finance
The different types of leverages and their importancein
business
The operating leverage, degree of operating leverage
calculations and its contribution to business risk.
The concept and determination of financial leverageand
its contribution to financial risk
Background..
In corporate finance,
leverage applies to the
use of certain fixed
costs (that act as
levers) that results in
a manifold increase
(or leverage) in a
firms profitability.
Background..
Operating leverage is the sensitivity of the
relationship between the sales and the earning
before interest and tax (EBIT), or the operating
profit of a firm, due to its fixed operating cost.
Here,
EBIT = earning before interest andtax
EBT = earnings before tax
PD = preference dividend
I = interest ondebt
t = corporate taxrate
DFL and Financial Risk
May lead bankruptcy or insolvency.
The more is the level of fixed cost financing of a
firm, i.e., use of debt, the more is its financialrisk.
While business risk Vs financial risk
The higher the amount of debt that the firm uses,
the higher the financial risk
EBIT-EPS Analysis
Financial leverage helps companies to increase their
earnings by using debt and preferred capital, i.e., fixed
cost financing.
PRACTICE..
Analyzing Alternative Financial Plans: constant EBIT
11
PRACTICE..