Operating and Financial Leverage^79
That depends. Suppose we sell each copy for 50 paise. Then, for each copy we sell we
receive 50 paise and spend extra 30 paise or 25 paise (depending on our choice of
machine) for the variable costs. The difference between the price and the variable
costs is referred to as the contribution margin. This margin represents the amount of
money available to be used to pay fixed costs and provide the firm with a profit.
If we use the slower machine, we receive 50 paise and spend 30 paise, leaving 20 paise
to be used toward paying the rent on the copy machine. If we sell enough copies, there
will be enough individual contributions of 20 paise a piece to pay the full Rs 10,000 rent
and leave some receipts for a profit.
So in operating leverage the decision boils down to the production levels that we have
or we anticipate and on that basis we decide the amount of fixed costs that we are
willing to bear. All this leads itself to breakeven analysis or cost-volume-profit analysis
that you have learned earlier.
Financial Leverage
Let's start our discussion of financial leverage with an example. Assume you were to
buy a small building as a piece of investment property. You buy the building for Rs
1,00,000 and pay the full amount in cash.
Suppose that an year later you sell the building for Rs 1,30,000. Your pre-tax profit is Rs
30,000. This is a 30% pre-tax return on your original investment of Rs 1,00,000.
As an alternative to paying the full Rs 1,00,000 cash for the investment, you might have
to put Rs 10,000 cash down and borrow Rs 90,000 from the bank at 15% interest. This
time when you sell the property for Rs 1,30,000 you repay Rs 90,000 to the bank, along
with Rs 13,500 interest. After deducting your original Rs 10,000 investment, Rs 16,500
is left as a pre-tax profit. This is a pre-tax return of 165% on your Rs 10,000 investment.
Compare the 30% we calculated earlier to this rate of return of 165%. That's financial
leverage for you!
Note that we had a net profit of Rs 30,000 without leverage, but only Rs 16,500 in the
leveraged case. Although we earned a higher return, we had less profit. That's because
in the unleveraged case we had invested Rs 1,00,000 of our money, but in the leveraged
case we had invested only Rs 10,000. If we have additional investment opportunities
available to us, we could have invested our full Rs 1,00,000, borrowed Rs 900,000, and
had a pre-tax profit of Rs 165,000 on the same investment that yields Rs 30,000 in the
unleveraged situation. Financial leverage can not only increase your yield from
investments, but can also allow you to consider projects that are much larger than what
would be feasible without borrowing.