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Understanding Leverage and Its Types in Capital Structure Analysis

Leverage involves the use of fixed costs to increase profits relative to changes in sales. This concept is crucial in analyzing how debt and equity impact shareholder returns and risks in a firm's capital structure. The types of leverage include Operating Leverage, Financial Leverage, and Combined Leverage, each playing a unique role in amplifying returns and risks. Operating leverage focuses on fixed operating costs' impact on profit changes, measured through the degree of operating leverage (DOL). It influences the break-even point, selling price, and variable costs, linking directly to business risk.

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Understanding Leverage and Its Types in Capital Structure Analysis

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  1. Leverage Leverage  Leverage means the employment of assets or funds for which the firm pays a fixed cost or fixed return.  The concept that is used to study the effects of various mix of debt and equity on the shareholder's return and risk in the capital structure of a firm is called leverage.

  2. Types of Leverage Types of Leverage ● Operating Leverage ● Financial Leverage ● Combined Leverage

  3. Meaning of Operating Leverage Operating leverage is defined as the use of fixed operating costs to magnify a change in profits relative to a given changes in sales. Contribution Operating ProfitsorContribution Operating Leverage = EBIT * EBIT = Earning before Interest & Tax *Contribution = Sales-Variable cost

  4. Degree of Operating Leverage The multiplier effect resulting from the use of fixed operating costs can be measured by the degree of operating leverage. The degree of operating leverage (DOL) at any level of output expressed as the ratio of the percentage change in operating profits to percentage change in sales. DOL=% Change in profits % Change in Sale % Change in EBIT % Change in Sale or

  5. Characteristics of Operating Characteristics of Operating Leverage Leverage ● It is related to the assets side of balance sheet. ● It is directly related to break-even point. ● It is related to selling price and variable costs. ● It involves business risk.

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