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Operating and Financial Leverages

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Part 1: What are the sources of operating leverage and financial leverage and explain their impact on operating and net income?

Part 2:Your organization (a not for profit group) is considering hiring a professional fund raise to assist in selling raffle tickets. This consultant is going to charge $10,000 (fixed cost) plus 45 cents (variable cost) for every person solicited. It is going to try to get donations of $5 per raffle ticket sold. In this case, break even would be just about 2,200 tickets sold. Your mailing list contains 5,000 names. Your organization must now decide how many tickets it is likely to sell. Remember if it sells less than 2,200 it makes no money. Should it undertake this project? State the assumptions that you made in arriving at your answer and defend your decision.

Part 3:Consider two industries, steel production and donut making. Which industry do you think has the highest degree of operating leverage? Give your answer to the first part, what should the level of financial leverage for each industry? Should both of these industries have similar degrees of combined leverage?

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The solution explains operating and financial leverages.

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Part 1: What are the sources of operating leverage and financial leverage and explain their impact on operating and net income?

Operating leverage is a measure of the extent to which, fixed operating costs are being used in an organization. (DWC)
Operating leverage is use of fixed costs by the firm in the operations. The degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.
Firms' Operating leverage is measured by:
DOL= Contribution/EBIT
Higher DOL indicates Higher Operating risk

Thus firm can increase the operating leverage by using the sources of operating fixed costs such as rent, depreciation, fixed overheads etc

Financial leverage refers to the use of fixed charges funds (debt) to improve the return on equity in the organization. The financial leverage employed by a company is intended to earn more return on the fixed-charge funds than their costs. The surplus (or deficit) will increase (or decrease) the return on the owners' equity. The rate of return on the owners' equity is levered above or below the rate of return on total assets. (I.M. ...

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