Integrative: Leverage and risk Firm R has sales of 100,000 units at $2 00 per un

Question

Integrative: Leverage and risk Firm R has sales of 100,000 units at $2 00 per unit, variable operating costs of $1.70 per unit, and fixed operating costs of $6,000. Interest is $10,000 per year. Firm W has sales of 100,000 units at $2.50 per unit, variable operating costs of $1.00 per unit, and fixed operating costs of $62,500. Interest is $17,500 per year. Assume that both firms are in the 40% tax bracket Compute the degree of operating, financial, and total leverage for firm R Compute the degree of operating, financial, and total leverage for firm W. Compare the relative risks of the two firms. Discuss the principles of leverage that your answers illustrate.

Explanation / Answer

Operating Leverage = Contribution (e) / Operating Income (g)

Finance leverage = Operating income (g) / Net profit (i)

Total leverage = Contribution (e) / Net profit (i)

or Total leverage = Operating leverage * Finance leverage.

Relative Risks:

Leverage is the use of fixed costs in a company’s cost structure.

Business risk is the risk associated with operating earnings and reflects

-sales risk (uncertainty with respect to the price and quantity of sales) and

-operating risk (the risk related to the use of fixed costs in operations).

Financial risk is the risk associated with how a company finances its operations (i.e., the split between equity and debt financing of the business).

In the given question, Firm W has more fixed costs and therefore more operational risk. To overcome this risk it has to achieve profit by increasing the sales price and reducing the variable operating costs.

Finance risk is more for Firm W as it has more interest to pay.

Firm R Firm W Sales in units (a) 100,000 100,000 Sales price per unit (b) $2.00 $2.50 Variable operating cost per unit (c) $1.70 $1.00 Contribution per unit (d) = b-c $0.30 $1.50 Conntribution (e) = a*d $30,000 $150,000 Fixed Operating cost (f) $6,000 $62,500 Operating Income (g) = e-f $24,000 $87500 Operating Leverage = e/g 1.25 1.71 Interest (h) $10,000 $17,500 Net profit (i) = g-h $14,000 $70,000 Finance leverage = g/i 1.71 1.25 Total Leverage = e/i 2.14 2.14

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