leverage

chandniwadhwani92
Finance Junkie
Posts: 166
Joined: Mon Oct 06, 2014 7:36 am

leverage

Postby chandniwadhwani92 » Fri Nov 28, 2014 5:50 pm

Degree of operating Leverage

SUppose there are two company A and B

Company A's Initial sales-50000
pRICE-4
Variable cost-3
Degree of operating leverage- 50000(4-3)/ 50000(4-3)-40000= 50000/10000
DOL- 5
It means for every one percent change in sales there will 5 % change in EBIT
If company increase its sales by 10%- EBIT will increase by 50%

Comapny B' initail sale is 100000
Fixed cost same for both the company= 40000 .price and variable cost also same
DOL- 100000(4-3)/100000(4-3)-40000= 100000/60000- 1.6
It means for every one percent change in sales there will 1.6% change in EBIT
If comapny b increase it sales by 10% EBIT WILL INCREASE BY 16%

MY QUESTION IS
As we know the company who has highest sale its EBIT incraeses more
But here in example PROJECT A has 50000 INITIAL SALES IT INCRAESE BY 10% ITS EBIT IS MORE HIGHER THAN COMPANY B WHOSE SALES EVEN ARE MORE INITALLY?
Why there is a inverse relation Less sales changing more EBIT

My second question is
Company prefers high DOL or low DOL

In both these company which should b preerable

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

leverage

Postby edupristine » Mon Dec 01, 2014 12:44 pm

Answer of first question:- Look at 40000 fixed cost which is to much in case of company A because their sales is only 50000, Hence the numerator is increased.
On the other hand company B is selling 100000 by paying 40000 fixed cost.Hence the numerator increased but comparatively less then company A.
Answer of second question:- Company prefer high DOL because they can make more money on leverage but it good to some extent only. Because company using more leverage is at risk.


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