HB 307 1st Edition Lecture 19 Capital Structure and Leverage Part 2 Operating Leverage Risk in Operations Business Risk o Variation in EBIT Fixed and Variation Costs and Cost Structure Mix of fixed and variable costs in a firm s operations is its cost structure Operating leverage defined o Refers to amount of fixed costs in the cost structure Breakeven Analysis o Used to determine the level of activity a firm must achieve to stay in business in the long run o Shows the mix of fixed and variable cost and the volume required for zero profit loss o Profit generally measured by EBIT o Breakeven diagrams occurs at the intersection of revenue and total cost o Represents level of sales at which revenue equals cost o Contribution Analysis o Every Sale makes a contribution of the difference between price P and variable cost V o C t P V o Can be expressed as a of revenue o Known as the contribution margin Cm o Cm P V P o Calculating the breakeven sales level o EBIT is revenue minus cost or EBIT PQ VQ Fc o Breakeven occurs when revenue PQ equals total cost VQ Fc or Q B E Fc P V Effect of Operating Leverage As volume moves away from breakeven profit or loss increases faster with more operating leverage The Risk Effect o More operating leverage leads to larger variations in EBIT or business risk These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute The Effect on Expected EBIT o Thus when a firm is operating above breakeven more operating leverage implies higher operating profits Degree of Operating Levarege DOL A measurement Operating leverage amplifies changes in sales volume into larger changes in EBIT DOL relates relative changes in volume Q to relative changes in EBIT Comparing Operating and Financial Leverage Similar in that both can enhance results while increasing variation Financial leverage involves substituting debt for equity in firm s capital structure Operating leverage involves substituting fixed costs for variable costs in firm s cost structure Both methods involve substituting fixed cash outflows for variable cash outflows Both makes risks larger as leverage increases Financial is more controllable than operating leverage Compounding effect of operating and financial leverage Both compound each other Changes in sales are amplified by operating leverage into larger changes in EBIT Combined effect can be measured using degree of total leverage DTL o DTL DOL x DFL