HB 307 1st Edition Lecture 19Capital Structure and Leverage Part 2Operating Leverage- Risk in Operations-Business Risko 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 Analysiso Used to determine the level of activity a firm must achieve to stay in business in the longrun o Shows the mix of fixed and variable cost and the volume required for zero profit / losso Profit generally measured by EBIT o Breakeven diagrams – occurs at the intersection of revenue and total costo Represents level of sales at which revenue equals cost o Contribution Analysiso 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 levelo 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 riskThese 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 implieshigher 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