If a company has high operating leverage, what would be the likely effect on its risk and return?a.Higher risk and lower returnb.Lower risk and lower returnc.Higher risk and higher returnd.Lower risk and higher return
Question
If a company has high operating leverage, what would be the likely effect on its risk and return?a.Higher risk and lower returnb.Lower risk and lower returnc.Higher risk and higher returnd.Lower risk and higher return
Solution
The answer is c. Higher risk and higher return.
Here's why:
Operating leverage refers to the proportion of fixed costs in a company's cost structure. A company with high operating leverage has a large amount of fixed costs, such as rent or salaries, that do not change with the level of output.
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Risk: High operating leverage increases a company's risk because it must cover its high fixed costs regardless of how well its goods or services sell. If sales are low, the company still has to pay its fixed costs, which can lead to financial distress.
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Return: On the other hand, when a company with high operating leverage increases its sales, a larger portion of each sale goes towards profit because the fixed costs have already been covered. This can lead to higher returns.
So, a company with
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