MGT201 Module 12 Topics 217-228 Preparation

Topic 217: Concept of leverage

The Leverage is actually a term which is taken from the point of view that using a lever, we can enhance our force or our strength meaning that if we use lever and can magnify it by applying even less force.

The concept of Leverage basically is that how we can maximize or enhance the profit of our shareholders. In one way, we try to earn more for the shareholders through this enhancement of profit but on the other side, the concept of Leverage is with reference to the Capital Structure. It means that how we can increase or decrease this profit or return by changing the capital structure.

Operating and financial Leverage:

So, Leverage is actually about the cost; the cost of the debt or the cost of debt financing. This cost of debt financing is actually fixed and when we say that Leverage is creating and actually this Leverage is created through fixed cost.

One fixed cost is our financial fixed cost and in addition to it we have an operational cost which we name Operating Expenses and see it with reference to the cost of goods sold or cost of production.

We have got two types of costs; one is Financial Cost and other one is Operating Cost. As a result we can have two different Leverages Financial Leverage and Operating Leverage. The Operating Leverage is actually the Leverage that is created because of the fixed operating cost and Financial Leverage is the Leverage which is created by because of fixed financial cost or in simple words the fixed rate of interest.

Use of fixed cost to enhance the return:

We can define Leverage as how we can increase the return of shareholder or equity holders by using fixed cost and that is the concept of Leverage. We will consider both the operating profit or profit after tax and return of shareholders or return on equity in it.

Leverage is due to Debt:

If we are focusing on financial Leverage then we say that this Leverage is because of Debt meaning that if we have to create financial Leverage then it will need fixed cost and there is not fixed cost of equity but the fixed cost is always of the Debt.

So, this means that if we want to create financial Leverage then we have to have some financing which have got some fixed cost and it is only debt that has got

Debt generally has fixed cost:

The Debt having fixed cost is something that creates Financial Leverage. On the other side, fixed operational cost and expenses create Operating Financial Leverage.

So, we say that if a firm wants to create Operating Leverage then it has to fixed one portion of its operating cost and if a firm want to create Financial Leverage then it has to fix the cost of one component of capital which is actually the cost of debt that can be fixed.

We can conclude our basic initial discussion that Leverage is actually dependent on the fixed cost. This fixed cost is related to the operations and the Leverage created from the operations will be called Operating Leverage and this will affect our profit means it will increase our profit. And that Leverage which arises from our fixed financial cost which we call Financial Leverage and this Financial Leverage increases our equity holders or return on equity.

Topic 218: Fixed and Variable Costs

There are two types of costs which are almost always there in every business organization.

In this lecture, we will discuss that what Fixed cost is and what is the impact of Fixed cost and similarly we will also talk about what is Variable Cost and what is the impact of Variable Cost.

The Fixed cost is one which is fixed meaning that cost which never changes but this is not the right concept about the Fixed cost as there is no cost in the world which is fixed forever.

But when we talk about the term Fixed cost which has specific meaning that let’s see it.