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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Leverages

Which of the following statements about leverages is correct?

A firm with no fixed operating costs has a degree of operating leverage of 1. In that case contribution equals EBIT, so a given percentage change in sales produces exactly the same percentage change in EBIT, with no magnification.

  1. AFinancial leverage arises from fixed operating costs such as rent and depreciation
  2. BOperating leverage measures the effect of fixed financial charges on EPS
  3. CA firm with no fixed operating costs has a degree of operating leverage of 1Correct
  4. DA firm with no debt has a degree of financial leverage greater than 1

Explanation

With no fixed operating costs, contribution equals EBIT, so DOL = contribution/EBIT = 1. Fixed operating costs drive operating leverage, not financial leverage, and fixed financial charges drive financial leverage. With no debt and no preference dividend, EBIT equals EBT, so DFL = 1, not more.

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