4. Financial leverage The following is a list of selected information for Liverp

Question

4. Financial leverage The following is a list of selected information for Liverpool Co. for the fiscal year ending 2011. You are an employee for Liverpool Co., and your boss needs help assessing the level of risk associated with the firm?s current financial position. Begin by calculating the degree of financing leverage for the change between 2011 forecasted operations and the operational increase of 60.00%. Your boss says, Looking good so far. However, I would like to know how we stack up against our strongest competitor, Everton Co. Compare the degree of operating leverage of Everton Co. with that of Liverpool Co. and then answer the following question. All else being equal, is Liverpool Co. more risky than, less risky than, or as equally risky as Everton Co., considering that the degree of operating leverage for Everton Co. is 1.06? Not enough information given More risky Less risky

Explanation / Answer

Answer

Degree of Financial leverage = % change in EPS / % change in EBIT

= ( 68.40/ 84.75) / ( 2280 / 3000)

= 0.80708/0.76

=1.06 times

Degree of Financial leverage for the change between 2011 forecasted operations and operational increase of 60.00% is 1.06 times

Degree of Operating leverage = % Change in EBIT/ % Change in Sales

= ( 2280 / 3000) / ( 120/200)

= 0.76 / 0.60

= 1.27 times

So Degree of Operating leverage is 1.27 times

Degree of operating leverage of Liverpool Co. is 1.27 times as against degree of operating leverage for Everton Co. is 1.06 times. All other things remaining the same, the higher the degree of operating leverage, the more volatile the EBIT figure will be relative to a given change in sales. So EBIT to sales of Liverpool Co. is more volatile compared to EBIT to sales of Everton Co. So All else being equal, Liverpool Co. Is more risky than Everton Co.

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