Question

A company is in the large shipbuilding industry with most of its operating costs fixed. The company has not used any debt to finance its operations. The operating leverage for such a firm is most likely:

-low.

-high.

-zero.

Answer 1

Option (b) is correct

The operating leverage of a firm with high fixed cost is higher.

Degree of operating leverage depends on fixed costs. If fixed costs are higher, then degree of operating leverage is higher and if fixed costs are lower, degree of operating leverage is lower.This can be seen below also.

Degree of operating leverage = Contribution / EBIT

where Contribution = Sales - variable cost, and EBIT is contribution - fixed cost

so when fixed costs are high, then denominator of the above equation will be lower, resulting in high degree of operating leverage.