Relationships between operating, financial and combined leverage
Discuss the relationships between operating, financial and combined leverage? Does the firm use financial leverage if preferred stock is present in its capital structure? What type of effect occurs when the firm uses operating leverage?
Financial leverage arises from financing a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholders. The decision to use debt or preferred stock in the financial structure of the corporation means that those who own the common shares of the firm are exposed to financial risk. Any given level of variability in EBIT is magnified by the firm’s use of financial leverage, and such additional variability is embodied in the variability of earnings available to the common stockholder and earnings per share. (Keown 390)
Operating leverage causes changes in sales revenues to lead to even greater changes in EBIT. due to financial leverage translate into larger variations in both earnings per share (EPS) and the net income available to the common shareholders (NI), changes in EBIT can ocurr. if the firm chooses to use financial leverage. It should be no surprise, then, to find out that combining operating and financial leverage causes rather large variations in earnings per share.