leverage

LEVERAGE

Submitted By : Rohit Raina0613-MBA-2013

LEVERAGE

Leverage is the employment of an asset/source of finance for which firm pays fixed cost/fixed return.

Type of Risks Business Risk Financial Risk

TYPES

1. OPERATING LEVERAGE.2. FINANCIAL LEVERAGE.

3. COMBINED LEVERAGE.

OPERATING LEVERAGE

It is a measure of how revenue growth translate into growth in operating income.

operating leverage arises because of the use of fixed operating expenses in a firm.

Operating leverage = Contribution/Operating profit.

OPERATING COST

1. FIXED COST.2. VARIABLE COST.3. SEMI-VARIABLE COST.

1. FIXED COST:-It is defined as those cost which do not vary with sales volume, they are a function of time and are typically contractual.

2. VARIABLE COST:-It is defined as those cost which vary directly with the sales volume.

3. SEMI-VARIABLE COST:-It is defined as those cost which are partly fixed and partly variable.

Fixed Cost

OPERATING LEVERAGE IN TERMS OF DOL

The DOL measure in quantitative terms the extent or degree of operating leverage.

DOL = ∆EBIT÷EBIT/∆Q÷Q EBIT = Q(S-V)-F , ∆EBIT = ∆Q(S-V) Q = Sales quantity in units. S = Selling price per unit. V= Variable cost per unit. F = Total fixed cost.

FINANCIAL LEVERAGE

It is defined as the ability of a firm to use fixed financial charges to magnify the effect of change in EBIT on the earning per share.

It is also called as trading on equity.

FINANCIAL LEVERAGEIN TERM OF DFL

Financial leverage can be more precisely expressed in terms of the degree of financial leverage.

DFL = ∆EPS÷EPS/∆EBIT÷EBIT EPS = [Q(S-V)-F-I](1-T)-D℗/N ∆EPS = [∆Q(S-V)](1-T)/N

COMBINED LEVERAGE

It is a combination of both operating leverage and financial leverage.

Combined leverage =∆EPS-EPS/∆Q-Q

EBIT – EPS ANALYSIS The EBIT – EPS analysis as a method to study the

effect of leverage, essentially involves the comparison of alternative methods of financing under various assumptions of EBIT.A firm has choice to raise funds for financing its investment proposals from different sources in different proportions.

ADVANTAGES

1. It allow trader to increase their exposure to particular positions.

2. Leverage allow investors to offset capital losses from other trading activities.

3. It is helpful in generating greater profits.4. It is helpful to reduce overall risk exposure.

DISADVANTAGES

1. The main drawback of leverage is its potential to scale up losses when the going gets tough.

2. Leverage is used only as a part of your trading strategy and does not form the sole backbone of your trading strategy.

3. Leveraged positions can lead to a total wipe out of your trading balance and over the years many traders have found themselves falling victim to the negatives effects of leverage.