Changes in sales cause changes in profits. Would the profit change associated wi

Question

Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverages? Explain your answer.

A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital structure for financing the expansion.

Should the asset investment and financing decisions be jointly determined, or should each decision be made separately?

How would these decisions affect one another?

How could the leverage concept be used to help management analyze the situation?

The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay cash dividends during the same year.

Discuss the meaning of those statements.

Explanation / Answer

1) Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage. By using fixed production costs, a company can increase its profits. If a company has a large percentage of fixed costs, it has a high degree of operating leverage. Automated and high-tech companies, utility companies, and airlines generally have high degrees of operating leverage.

Formula to calculate Operating leverage is as follows

or , Contribution / Net income

From the above , it can be seen that any change in sales will affect profit and operating leverage as well.

In a sense, operating leverage is a means to calculating a company's breakeven point. However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales. Accordingly, companies with high operating leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other conditions that tend to boost sales.

Increased operating leverage means more FIXED COSTS (Denomoinator in the above formula decreases if fixed costs increase.) . So,profit change associated with sales changes will definitely be small- with high break-even point and lower margin of safety -- if a firm increased its operating leverages

2) This involves decision-making regarding the acquisition of the right type of asset/s and the mode of financing

the purchase- whether by equity/ debt/or both . It is only prudent for the firm to assess the asset investment and financing decisions jointly. For, the highly automated process would require fancy, new equipment (capital intensive) so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. If sales fell, the process which demands more fixed costs might be detrimental to the firm if it has much debt financing. The less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped; thus, debt financing would be more attractive. Operating leverage and financial leverage are interrelated. The highly automated process would increase the firm's operating leverage; thus, its optimal capital structure would call for less debt. On the other hand, the less automated process would call for less operating leverage; thus, the firm's optimal capital structure would call for more debt.

3) Retained earnings are the cash that company has.While this seems like “free” financing because

it doesn’t have to be raised in the market, it does have an opportunity cost. If the firm did not use

this money for financing it could return it to the shareholders. In other words, using retained

earnings is a form of equity finance because it takes money from shareholders. Since it is equity

finance, it should be priced at the cost of equity.Firms seem to have a preference for retained earnings to fund investments, for a variety of reasons:

Retained earnings are actually a little bit cheaper than new equity financing since the firm does not have to pay the cost of issuing shares. In addition, outside investors may not have good information about the prospects of the firm,

which would make them hesitant to invest in newly-issued equity.

Hence when cheaper funding alternative is available a company may not resort to raise funds through new equity issue and pay dividends on it.

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