Question

Calculate Operating Leverage and Financial Leverage under situations X, Y and Z and financial plan 1,2 and 3 respectively form the following information relating to the operation and capital structure of P, Q and R limited. Also, find out the combinations of operating and financial leverage which give the highest value and the least value.

Installed Capacity(Units)	1200
Actual Production and Sales (Units)	800
Selling Price per unit	15
Variable Cost per unit	10
Fixed Cost
Situation X	1000
Situation Y	2500
Situation Z	5000
Total Capital Required	10,000

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Capital Structure

	1	2	3
Equity	50%	75%	25%
Debt	50%	25%	75%
Cost of Debt		12%	15%

Answer 1

Operating Leverage = Fixed Costs/Total Costs

Hence, for the three situations given, Operating leverages will be = 1000/10000 = 10%; 2500/10000 = 25%; 5000/10000 = 50%.

Financial Leverage = Debt/Equity.

So, for the three situations, Financial Leverage will be = 0.5/0.5 = 1; 0.25/0.75 = 0.33; 0.75/0.25 = 3.

The highest value will be when the product of the two leverages will be the highest i.e. 3 x 50%= 1.5. This is for the case when the fixed costs are 5000 and the Debt is 75%.

The lowest value will be when the product is lowest i.e. 0.33 x 10% = 0.033. This occurs when the Debt is 25% and the fixed cost is 1000.