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Faisal Hameed
Roll no 123
MBA (2nd)

Miss Haseena Nazeer

Dated: 23-03-2009
Leverage refers to the results from the use of fixed cost assets
or funds to magnify returns to the firm’s owners.
It has two types:
Operating Leverage:
The potential use of fixed operating costs to magnify the effects of
changes in sales on the firms earning before interests and taxes (EBIT)
Financial Leverage:
The potential use of fixed financiual costs to magnify the effecs of
change s in earnings before interest and taxes on the firm’s earnings
per share.

Before making any decision, first we see the basis on which an industry
or economy should decide to adopt leverage.
Revenue Stability:
If the demand of the product is stable and stable prices are ensuring
stable revenue from sales, it will reduce business risk. Firms with low
business risk tend towards highly leveraged capital structure and vice
Cost Stability:
It refers to the effective predictability of input prices such as those for
labor and materials. The more stable the input prices are, the lower
the business risk is, and vice versa.
Firms with high business risks tend towards low highly leveraged
capital structure.

• We had discussed, if the environment is not certainly favorable,

a firm should convert its fixed cost to variable cost.
• One the other hand, if the environment is certainly favorable, a
firm should convert its variable cost into fixed cost.
In simple words we can say that the certainty of environment (like
stability of Revenues and costs) directly affects the decision of
adopting leverage.

In Pakistan, though the environment is uncertain. Neither revenues

nor costs are stable. Therefore, leverage is not recommended.

 Which Industry should adopt leverage and which should

On the basis of above discussion, it is recommended that the industry
with labor intensive structure such as looms, dairy farming, live stock
etc should move towards fixing there variable cost. It will reduce their
Operating Variable cost and increase operating fixed cost that would
generate Leverage.

The industries with capital intensive structure should keep a close eye
on investing more and more on fixed assets like new plant and
technology. It will not only increase their Operating fixed cost (like
lease rental and depreciation) but also Financial fixed costs (like
financial lease or interest payments)

 To what extent leverage should be adopted?

It is a very technical decision because every industry has its own cost
and capital structure, degree of operating and financial risks etc. But
we can generalize the decision that:
Firms with the debt equity ratio below 40:60 have the potential to
adopt leverage. 40:60 indicate that total investment in assets is 60%
financed by the owners and 40% financed by the creditors. Means the
firm is in the position that it can expand its credit lending to meet the
requirement of changing technological requirements.
A firm which is already above 50:50 and is near 60:40 has no more
potential to expand its credit lending. If it goes on with leverage, there
is a clear chance of insolvency and liquidation due to debt burden.