Calculating Leverage

There are two types of leverage: operating and financial leverage. Operating leverage is the amount of fixed costs in the organizations financial structure, while financial leverage measures the degree of debt. A lever is a device that allows you to move big objects that you could not normally move, so it allows you to magnify your output. The word leverage is derived from the word lever and it means that you can magnify your financial results through the use of leverage. Unfortunately, that does not always result in a good outcome as not only positive results are magnified, but negative results are magnified as well. For example, a firm with a combined leverage of 4, will see a 4% increase in earnings per share with only a 1% increase in sales. Likewise, a 1% decrease in sales will result in a 4% decrease in earnings per share. What this means for companies is that they need to be aware of the degree of leverage (financial and operating) of their firm and the impact this will have on the financial results. If they anticipate a downturn in sales and have a high degree of leverage, they may proactively attempt to reduce leverage by cutting back on fixed costs and debt in anticipation of the downturn. The intent of this assignment is to calculate the degree of financial and operating leverage of the firm and to see its impact on the break-even point.

Instructions

Use the information below to complete your assignment. Fly Away Corporation makes pumps for the aviation industry. The income statement is shown below: Fly Away CorporationSales (5,000 pumps at $25)$125,000 Less: Variable costs (5,000 pumps at $10)$50,000 Fixed Costs$40,000 Earnings before interest and taxes (EBIT)$35,000 Interest $7,500 Earnings before taxes (EBT)$27,500 Taxes (@35%)$9,625 Earnings after taxes (EAT)$17,875 Shares Outstanding: 5,000 EPS$3.57 Use the information from the income statement to compute the following:

1. Degree of operating leverage.
2. Degree of financial leverage.
3. Degree of combined leverage.
4. The break-even point.
5. Explain the difference between the two types of leverage.
6. Recompute with the fixed costs increased to $50,000 and explain what happened to the break-even point.