FREE IGNOU MCO-07 SOLVED ASSIGNMENT 2023

Question 4: (a) What is operating leverage and financial leverage? What is their significance?

Operating Leverage: Operating leverage refers to the extent to which a company’s fixed operating costs are employed in its cost structure. It measures the sensitivity of a company’s operating income (earnings before interest and taxes – EBIT) to changes in its sales revenue. A company with high operating leverage has a significant proportion of fixed costs in its cost structure, which means that a small change in sales can result in a proportionally larger change in operating income.

The formula to calculate operating leverage is:

Operating Leverage = Contribution Margin / EBIT

Where:

• Contribution Margin = Sales – Variable Costs
• EBIT = Earnings Before Interest and Taxes

Significance of Operating Leverage:

• Risk and Profit Potential: High operating leverage can magnify both profits and losses. When sales increase, the company experiences a higher percentage increase in operating income, leading to greater profitability. However, if sales decline, the company faces a larger decline in operating income, increasing the risk of losses.
• Break-Even Point: Operating leverage impacts the break-even point, which is the level of sales at which the company neither makes a profit nor incurs a loss. Companies with high fixed costs have a higher break-even point, requiring a higher sales volume to cover their fixed expenses.
• Decision Making: Operating leverage plays a role in the decision-making process, especially when considering changes in production levels, cost structures, or pricing strategies. Managers need to be aware of the potential impact on operating income when making these decisions.

Financial Leverage: Financial leverage, on the other hand, refers to the use of fixed-cost financing, such as debt and preference shares, to magnify the return on equity (ROE) and earnings per share (EPS) for shareholders. It involves the use of borrowed funds to finance a portion of the company’s assets or operations. When the return on investment (ROI) exceeds the cost of borrowing (interest rate on debt), financial leverage enhances shareholders’ returns.

The formula to calculate financial leverage is:

Financial Leverage = EBIT / EBIT – Interest

Where:

• EBIT = Earnings Before Interest and Taxes

Significance of Financial Leverage:

• Return on Equity (ROE): Financial leverage can boost ROE when the return on assets (ROA) exceeds the interest rate on debt. In such cases, the return available to equity shareholders is higher than if the company was entirely equity-financed.
• Risk and Solvency: Higher financial leverage increases the company’s financial risk. If the company’s operating income falls below the level required to cover the interest expenses, it may face difficulties in meeting its debt obligations, leading to financial distress.
• Cost of Capital: The use of debt in the capital structure can lower the weighted average cost of capital (WACC) due to the tax deductibility of interest expenses. This can result in a lower cost of financing and higher profitability if managed prudently.

   

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