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Combined Leverage

Combined Leverage Assignment / Homework Help
Combined leverage, as the name implies shows the total effect of the operating and financial leverages. In other words, combined leverage shows the total risks associated with the firm. It is the product of both the leverages.

Degree of Combined Leverage (DOL) = DOL * DFL

        Degre of combined leverage

As represented above, the degree of combined leverage measures the percentage of change in Earnings per share as a result of a percentage change in Sales. The combined leverage can work in either direction. It would be favorable if sales increase and unfavorable in the reverse scenario. It serves as an important measure in choosing financial plans as EPS measures the ultimate returns available to the owners of the company. For example, if the company invests in more risky assets than usual, the operating leverage of the company will increase. If the company does not change its capital structure, the financial leverage will not change. These two actions will increase the combined leverage of the firm, as a result of increase in the operating leverage.

As said, the combined leverage measures the total risk of the firm. If the firm wants to maintain the risk or not to increase the risk, it would try to lower the financial leverage to compensate for the increase in operating leverage so that the combined leverage remains the same. Lowering the financial leverage can be done if the new investments are made in equity rather than debt. Similarly, in cases where the operating leverage has decreased due to lower fixed operating costs, the firm can think of having a more levered financial structure and still keep the combined leverage constant, thereby increasing the earnings per share of the equity holders. These are the advantages of measuring the combined leverage.

Example :

A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. The fixed interest expenses (non-operating) are $25,000 and the firm has 10,000 shares outstanding. Let us evaluate the combined leverage resulting from sale of 1) 2000 units & 2) 3000 units. Tax rate = 35%.

        combined leverage example
A combined leverage (total risk) of 4 indicates that for every $1 change in sales, there would be a $4 change in the Earnings per share in either direction.

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