Valuing Preference Shares Using Dividend Discount Model
The dividend discount model is also used to measure the value of preference equity in addition to forecasting the value of ordinary equity. There are certain assumptions and clarifications that need to be made regarding the use of dividend discount model for valuing preference equity. The purpose of this article is to provide this information […]
Common Issues with Revenue Generated from Broadcasting Right
In the previous article, we have already seen that broadcasting rights and the revenue from the sale of these broadcasting rights have become a very important part of the overall revenue generated by sports leagues all over the world. It would not be far-fetched to say that the economic fundamentals of sports leagues would be […]
Why Blockchain May Not be Suitable for Commercial Banking?
As far as technology enthusiasts are concerned, blockchain is the most important invention since the wheel! It is very easy to find literature where technical gurus are praising blockchain as being the solution to all technology-related problems being faced by mankind. This overenthusiasm is the reason that most people believe that blockchain will revolutionize many […]
The Role of Commercial Banks In Liquidity Management
Due to increasing globalization in the world economy, a lot of multinational corporations today have their businesses spread out across several geographies. This creates several management problems for multinational companies. Not only do they have to struggle with the complexity of managing personnel and operations in many countries but they also have to ensure proper […]
Bielard, Biel and Kaiser (BBK) Model
The main criticism of the Barnewall model was that it only classified investors into two types. This created an oversimplification. Practitioners of behavioral finance wanted the classification to be more accurate and inclusive. This is the reason why they started creating another psychographic model. This model is called the Bielard, Biel, and Kaiser model, i.e., […]
The degree of operating leverage of a company is very important from an investor’s standpoint. Although it shows the riskiness of a venture, it also shows the efficiency of a company. Just like, financial leverage arises out of the capital structure of a company, operating leverage arises out of its cost structure.
If a company has too many expenses which are fixed in nature, the company is said to have high operating leverage.
Typically companies that are highly mechanized have high operating leverage. This is because they have replaced labor which is a variable cost by depreciation on machinery which is a fixed cost. This creates debate whether having a high operating leverage is a bad thing.
Henry Ford was amongst the first to use operational leverage on a large scale and build cars at a fraction of what it would cost earlier. This idea was soon followed by many others and high operating leverage became the norm.
Degree of Financial Leverage = % Change in Sales / % Change In EBIT
The ratio makes a reasonable assumption that accounting policies have not changed so much that the Sales and EBIT figures do not remain comparable across companies or across time.
Consider for example, the movie business. The costs incurred to make the movie are fixed. Hence when tickets are sold, the first few tickets go towards recovery of the cost of production. However, once a breakeven point has been reached, entirely all the money goes towards the bottom line. Hence a slight change in sales has the capability to magnify and bring about a big change in EBIT.
Since most of the costs are fixed, in the vent of a downturn, the company does not have the opportunity to cut costs. In many cases, companies are not able to fulfill their requirements to meet the fixed cost obligation. Whereas all companies are hurt in the event of a downturn, companies with excessively high operating leverage are wiped out in such events.
Whether operating leverage is good or bad for a company depends on the nature of its operations and stability of its cash flow streams. In case of stable operations, high operational leverage in desirable and even recommended.
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