Hello Everyone,
I believe if company’s degree of operating leverage (DOL) declines then it’s business risk increases. Because what I understand is, if DOL is 1.38% Then this indicates that every 1% change in the company’s sales will change the company’s operating income by 1.38%.
So in that sense if DOL declines then business risk should increase.
Please clarify above understanding.
Pls refer attached image Q.16 wherein it is shown if DOL declines business risk also decline.
Thanks.
No. Your understanding is completely incorrect. You should spend more time in the chapter, if possible, go through the Level 1 Core Reading Corporate Finance/Issuers Leverage Chapter. You may also refer to Sanjay Sir’s Level 1 notes on the chapter
DOL of 1.38 indicates 1% increase/decrease in sales would increase/decrease EBIT by 1.38%.
If DOL decreases, say to 1.2, the variability of EBIT would be 1.2% increase/decrease with a percentage change in Sales.
Business Risk refers to variability of EBIT.
So, decrease in DOL decreases Business Risk.