Nov 26, 2020 in Business

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Coursework on Operating Leverage

Operating and Financial Lease

Operating leverage is the ability of the firm to magnify the effects of sales on its earnings before interest and tax (EBIT) using the fixed cost (Zhang, 2005). Fixed cost includes depreciation, taxes, advertising expenses, administrative cost, equipment, and technology (Sagi & Seasholes, 2007; Zhang, 2005). A firm can significantly increase its profits by using fixed production costs. If a company has a large percentage of its fixed cost, it means that this company has a high degree of operating leverage. On the other hand, financial leverage is the financing of a firm's assets using, debt or preferred stock. Both types of leverages may boost a firm's return but they increase risks as well (Kogan, 2004).

Operating Lease

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A firm with a higher contribution margin or words excess of sales over variable cost has the potential of creating larger profits than a company with a lower contribution margin or contribution leverage (Novy-Marx, 2007). The high contribution margin means the break-even point is lower; hence if more units are sold above the break-even point, the profit gets higher. Moreover, the contribution that the sales make to profit is greater than when the costs are variable. However, the problem with this type of leverage is that if the company has very high fixed costs, the firm might have difficulty in selling enough units to break even resulting in losses (Novy-Marx, 2007).

Financial Leverage

A company financed by debt makes profits, increasing the shareholder's earnings. In addition, the additional earned profits can be reinvested to increase production without the need to dilute the earnings of shareholders, hence, increase the profit per share (Davis et al., 2000). However, if the firm is over-leveraged and sales fall, there can be a cash flow problem that results in defaulting on the debt. Companies with a significant amount of debt earnings are more unpredictable than those with manageable debts. From the shareholder's perspective, financial leverage runs the highest risk because interest is paid before any dividends are issued. Both of these two types of leverages have their fair share of merits and demerits; their use in the firm may depend on several other things, for example, the nature of the capital formation, the availability of technology for cost-effective production, and the state of the economy. It should be recalled that the operating leverage is concerned with the relations between sales and profit while financial leverage is concerned with the relation between sales and earnings per share (Carlson et al., 2004). The comparison of both leverages has been conducted below.

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Operation leverage

Financial leverage




Interest on loan/internal rate of return 10%



Tax 41%



Tax shield



Earnings after tax



Earnings per share(5000 shares)



In the table, the internal rate of return is charged against EBIT in the operating leverage, while interest is charged EBIT on financial leverage. There is a tax savings shield of $131200, which is then given to shareholders as earnings. Moreover, using debt as leverage has proven to be a successful tool during an inflationary period.

Memo 01

Project Valuation

Valuation analysis is the evaluation of the potential merits of projects or the value of assets or business (Kogan, 2004). In this assignment, the projects are valued to find the one that realizes the best return on capital invested. Valuation answers the question of whether it is worth the investment. This analysis is based on the projections of the future financial outflow. In the assignment, the investor is advised on which investment project is worth investing in. The table below shows the analysis of the project.

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Project 2






































B/C ratio





First 113%,2nd 4.9%


7 years

2 years

3 years

26 years

First 1 year, second 24years













Valuation using the NPV

Net present value is the difference between the present value of the cash inflow and the present value of the cash outflow (Davis, et al., 2000). In this valuation, the net present value was used to get the project that had the best net inflow. Project one has the highest net present value, followed by projects 4,3,2,5 in that order. Project five had two parts; the first part had a very positive NPV while the last part performed very weak.

Valuation using the payback time

The payback time is the time required for the amount invested to be recouped by the cash outflow generated by the asset (Davis, et al., 2000). In a way, it is one of the methods used to calculate the risk associated with the project. When calculating the payback period, the initial cash outlay is divided by the cash generated by the project per year. It is assumed that the cash outflow is uniform every year. The payback time method picked number two as the project with the shortest payback time among all projects. It was closely followed by projects three, one, four, and five respectively.

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Using the Internal Rate of Return

The internal rate of return is the amount a given project is expected to generate (Davis, et al., 2000). Mostly, the internal rate of return is used to rank several prospective investments a firm is considering. If all other economic factors are constant, the project with the highest internal rate of return will be considered. In this assignment, the project with the highest rate of return projects three with 12 percent, followed by project one with 11 percent, projects four, two, and five followed in that order. The internal rate of return was calculated by looking at all aspects of every project. It is not very accurate because the market variables were not given. The benefit-cost ratio on the other hand measured the amount used in the project versus the money gained from the project. Using this method the project that fetched a lot of money is project one followed by projects four, three, two, and five respectively. Any organization should evaluate their projects before they commit the resources to them to avoid investing a lot of resources in a project that cannot fetch much.

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