Question 3 OR (b)
Operating and financial leverage; the significance of combined leverage
9 marks
- Time to write
- About 18 minutes
Question
Question 3 OR (b) · 9 marksDistinguish between Operating leverage and Financial leverage. How are the two can be measured? Examine how significant combined leverage is in the financial planning of a firm.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Distinguish…How…?Examine…3 asks, each with its own marks below. Answer all 3.
- Distinguish betweenSet the differences out in a table, basis by basis, not as two separate essays.
What the paper leaves open
"How are the two can be measured?" is printed so and kept.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Distinction between operating and financial leverage 3 marks 5 min
- 2 Measurement of each 3 marks 5 min
- 3 Significance of combined leverage 3 marks 5 min
- Check: every ask answered, key terms underlined 2 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Distinction between operating and financial leverage
| Basis | Operating leverage | Financial leverage |
|---|---|---|
| Relationship | Between sales and EBIT | Between EBIT and EPS |
| Arises from | Fixed operating costs in the cost structure | Fixed financial charges (interest, preference dividend) in the capital structure |
| Risk shown | Business (operating) risk | Financial risk |
| Decision it relates to | Investment and cost-structure decisions | Financing (debt-equity) decisions |
- Degree of operating leverage = % change in EBIT ÷ % change in sales, or contribution ÷ EBIT.
- Degree of financial leverage = % change in EPS ÷ % change in EBIT, or EBIT ÷ (EBIT − interest − preference dividend ÷ (1 − t)); with no preference shares, EBIT ÷ EBT.
- For example, with a DOL of 3, an 8% rise in output raises EBIT by 24%; with a DFL of 2, a 5% rise in EBIT raises EPS by 10%.
Significance of combined leverage in financial planning. Combined leverage = DOL × DFL = % change in EPS ÷ % change in sales: it shows how a change in sales flows through to EPS, i.e. the firm's total risk.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
- It lets the firm balance the two risks: a firm with high operating leverage (high fixed costs) should keep financial leverage low, and a firm with low operating risk can afford more debt, so that total risk stays acceptable.
- It shows how sensitive EPS, and so the share price, is to a fall in sales, which helps in planning the capital structure and the level of fixed costs together.
- It is undefined at the financial break-even point and very high near it, warning of the danger zone.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Distinction between operating and financial leverage | 3 |
| 2 | Measurement of each | 3 |
| 3 | Significance of combined leverage | 3 |
| Total | 9 |
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