Villaseñor, Jerome A.

BSBA FM 3-2
Nov. 8, 2020

FIRST GROUP REPORTER (SUMMARY)

The initial group reporter discussed about the contribution margin, degree of operating

leverage, degree of financial leverage as well as the hamada equation. Let’s first discussed

about the Contribution Margin.

Contribution margin. It is a useful concept to analyze the cost structure of your company, to

figure out what kind of volumes you need to make your business worthwhile. According to

Investopedia, Contribution Margin can be stated on a gross or per-unit basis. It represents the

incremental money generated for each product/unit sold after deducting the variable portion of

the firm’s cost. Contribution margin shows you the aggregate amount of revenue available after

variable costs to cover fixed expenses and provide profit to the company.

The formula for the contribution margin is:

Contribution Margin = Revenue –Variable cost

Degree of Operating Leverage. When a high percentage of total costs are fixed, the firm is said

to have a high degree of operating leverage. Business risk depends in part on the extent to which

a firm builds fixed costs into its operations—if fixed costs are high, even a small decline in
sales can lead to a large decline in ROIC (return on invested capital) which is the calculation

used to assess a company's efficiency at allocating the capital under its control to profitable

investments. Therefore, the higher a firm’s fixed costs, the greater its business risks. Higher fixed

costs are generally associated with more highly automated, capital-intensive firms and industries.

Degree of Financial Leverage. Leverage is used to describe the capability of a firm or company

to utilize its fixed cost assets or funds to increase the return on its equity shareholders. If the

company makes more profit by investing this borrowed money in its business activities than it

pays in interest, the company’s shareholders will obtain higher payments from their shares. But if

the company makes less profit than it pays in interest, shareholders will receive less money.

Hamada equation. It distinguishes the financial risk with that of the business risk of a levered

firm. A levered firm’s capital structure consists of both equity and debt. Sometimes, when the

debt increases more than the optimal, it also increases the cost of equity and debt. It would lead

to a new and increased cost of fresh capital. Hamada equation is applied to measure the increased

cost of equity due to the increased financial leverage.

The formula for the Hamada equation is:

βL=βU[1+(1−T) (D/E)]

Where:

• βL= Levered beta

• βU= Unlevered beta*

• T= Tax rate

• D/E= Debt to equity ratio*