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- Leverage is the influence which an independent financial variable has over a dependant/related financial variable.
- Operating leverage examines the effect to the change in the quantity produced on the EBIT of the company and is measured by calculating the Degree of Operating Leverage(DOL).
- A large DOL indicated that small fluctuations in the level of output will produce large fluctuations in the level of operating income.
- DOL is a measure of the firm's business risk. Business risk refers to the uncertainty or variability of the firm's EBIT. So, every thing else being equal, a higher DOL means higher business risk and vice-versa.
- The financial leverage measures the effect of the change in EBIT on the EPS of the company. Financial leverage refers to the mix of debt and equity in the capital structure of the company. The measure of financial leverage is the Degree of Financial Leverage(DFL).
- If the management decides to finance a part of the total investment required of through debt financing, the following two factors are important: The proportion of total investment which the management decides to finance through debt(Debt Equity Ratio the firm aspires to) and the interest rate on borrowed funds.
- The greater the tax rate, the more is the tax shield available to a company which is financially leveraged.
- As the company becomes more financially leveraged, it becomes riskier, i.e., increased use of debt financing will lead to increased financial risk which leads to: Increased fluctuations in the return on equity and increase in the interest rate on debts.
- The greater the use of financial leverage, the greater the potential fluctuation in return on equity.
- As the interest rate increases, the return on equity decreases. Even though the rate of return dimimishes, it might still exceed the rate of return obtained when no debt was used, in which case financial leverage would still be favorable.
- A combination of the operating and financial leverages is the total or combined leverage. Thus, the Degree of Total Leverage (DTL) is the measure of the output and EPS of the company. DTL is the product of DOL and DFL.
- There is a unique DTL for every level of output. At the overall break-even point of output the DTL is undefined. If the level of output is less than the overall break-even point, then the DTL will be negative. If the level of output is greater than the overall break-even point, then the DTL will be positie. DTL decreases as the quantity of sales increases and reaches a limit of one.
- DTL measures the changes in EPS to a percentage change in quantity of sales.
- DTL measures the total risk of the company since it is a measure of both operating risk and total risk.