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Chapter 14. Planning Profits

The concepts of operating leverage and financial leverage are key to understanding how a company will fare in fluctuating market conditions. A firm is said to be leveraged whenever it incurs either fixed operating costs (operating leverage) or fixed capital costs (financial leverage). More specifically, a firm's degree of operating leverage is the extent to which its operations involve fixed operating expenses, such as fixed manufacturing costs, fixed selling costs, and fixed administrative costs.

A firm's degree of financial leverage is the extent to which that firm finances its assets by borrowing. More specifically, financial leverage is the extent to which a firm's Return on Assets exceeds the cost of financing those assets by means of debt. The firm expects that the leverage acquired by borrowing will bring it earnings returns that will exceed the fixed costs of the assets and of the sources of funds. The firm expects that these added earnings will increase the amount of returns to shareholders.


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