The Cost of Capital; Financial Leverage; Which Counts Most - Term Paper Example

November 03, Operating Leverage; The Cost of Capital; Financial Leverage; Which Counts Most? Introduction: In finance, leverage is a common term for any method to multiply incomes and expenses. It is the beneficial condition of having a comparatively small quantity of cost yields relatively high stages of incomes. This report provides the comparison of operating leverage, cost of capital and financial leverage. Operating Leverage: In general, the higher the operating leverage, the more an organization’s profits. It is also influenced by variation in sales volume. The high sale will result in higher profits and a reduction in variable costs signifies that the organization does not have to incur any extra expenses for each unit sold. An increased volume of sales will enable to company to save gain benefits from its fixed costs. The idea of operating leverage was initially developed for utilizing in capital budgeting. Operating leverage is a significant concept as it affects how responsive profits are to transforms into sales volume. “The Degree of Operating leverage is a function of the cost structure of a firm and is usually defined in terms of the relationship between fixed cost and total costs. A firm that has high fixed costs relative to total costs is said to have operating leverage. A firm with high operating leverage will also have higher variability in operating income than would a firm producing a similar product with low operating leverage” (Choi 20). Other things remaining the same, the high difference in operating income will guide to a high beta for the industry with higher operating leverage. It is helpful to recognize how operating profit will vary with a given change in units formed; operating leverage is helpful to decide the business risks. Operating leverage can also be understood as the degree to which an organization utilizes fixed costs in creating its goods or offering its facilities. A fixed cost contains advertising expenses, equipment and technology, administrative costs, taxes, and depreciation. However, it excludes interest on debt, which is an element of financial leverage. By using fixed production costs, an organization can raise its earnings. If an organization has a high amount of fixed costs, it has a high level of operating leverage. High-tech and automated companies, airlines, utility companies etc commonly have high amounts of operating leverage. The difference between variable and fixed costs is an old idea. This separation of costs by behavior is the basis for breakeven analysis. “The idea of “break even analysis” is based on the simple question of how many units of product or service a business must sell in order to cover its fixed costs before beginning to make a profit. Presumably, unit prices are set at a level high enough to recoup all direct unit costs and leave a margin of contribution toward fixed cost and profit” (Helfert 193). Once adequate units have been sold to accrue the total contribution required to offset every fixed costs, the margin from any extra units sold will become revenue unless a latest layer of fixed expenses has to be added at any future point to support the high volume. Understanding this attitude will enhance the insight into how operational features of a business involve the elements of financial projections and planning. This information is also useful in setting operational strategies, which, particularly in an unstable business setting might, for instance, focus on reducing fixed costs during outsourcing certain operations. Cost of Capital: The cost of capital means the required rate of return for making capital budgeting. Cost of capital comprises the cost of debt and the cost of equity acquired through different sources. Cost of capital is the average rate of return required by the investors for their long term investments such as equity fund, preference fund and long term capital. When the firm makes long term investment then it should make an estimate of cost of capital. It is essential because the cost of capital has a bearing on the return from such investments. The cost of capital varies according to the volume of risk involved in the investment. If there is high volume of risk in investment then the cost of capital would be high compared to the low risk investment and income. Cost of capital is the central concept in every financial decision making. Acceptance or rejection of the project depends upon the cost that the company has to pay for the project investment. Company would select investment which is expected to earn higher return than the investment. In other words the cost of capital provides the guideline for optimum capital structure for the company. For calculating the cost of capital, the financial manager has to go through the following stages: “Determine the type of funds to be raised and their share in the capital structure, determine cost of each type of funds and calculate combined cost of capital of the company by giving weights to each type of funds in terms of proportion of funds raised to total funds” (Akrani para. 7). The simple form of the cost of capital happens in a manufacturing company with durable capital goods. In this form a producer obtains capital goods through rents and investment or leases them to earn income. “The cost of capital plays a natural role in the management of capital, since it transforms the price of acquisition of a capital good into a rental price that generate income. The cost of capital can be avoided by postponing acquisition results in foregoing the rental value” (Jorgenson & Yun 23). The rental cost of capital facilities in the unit price of utilizing a capital good for a particular period of time. For instance, a building can be rented for a number of months or years, an automobile can be leased for days or weeks, and computer time can be rented by the minute or the second. The cost of capital changes the acquisition cost of an asset into a suitable rental cost. The rate of return will depend on the cost of investment in capital with reference to the time for which the money is blocked. Financial Leverage: Financial leverage means the degree or extent to which a company uses borrowed funds in its business activities. A company which is highly leveraged may be at risk if they cannot repay the debt. High debt fund in the business is not a good indication as it increases the liability of the company. Moreover, they will have to pay some fixed amount as interest. Financial leverages are not bad in all time, however, it is helpful to increase the return to shareholders and sometimes it will help the company to reduce the tax liabilities in the business. Financial leverage would influence the earning per share of the company. Financial leverage is pertaining to the use of debenture and preference shares in a company’s capital structure. In financial leverage, if return exceeds the cost of capital it will be good for the company. On the other hand if there is high financial ratio in the company it would bring risk in the firm. High financial leverage is riskier to the firm as long term debt has to provide regular interest even if the firm has no profit. “At some degree of financial leverage the cost of debt rises because of increased risk with the higher fixed charges. When this happens, riskiness of the firm also increases in the eyes of equity investors who start expecting a higher return to compensate for the increased risk burden” (Unit 13L Leverage Analysis 56). Comparison between Financial Leverage and Cost of Capital: Financial leverage relates to the amount of debt fund in the capital structure of the company whereas the cost of capital relates to the required rate of return that the investor is expecting from investment. High financial leverage in the business is riskier if the company involves more debt fund in its capital structure. In this situation it will be difficult for the company as they will have to pay fixed charges as interest towards the debt. When companies make investment they primarily consider about the cost of capital because cost of capital is will relate to the average return on investment. Financial leverage means the usage of borrowed fund in company’s investment compared to equity fund whereas operating leverage means how revenue growth influence growth in operating income. Both operating and financial leverage measures the changes in earning of the company due to the presence of fixed charges in the company’s capital structure. Operating leverage shows the changes of Earning Before Interest & Tax (EBIT) according to the changes in sales. At the same time financial leverage shows changes of earning per share according to the changes in EBIT. Financial leverage is mainly considered by the huge business firms whereas operating leverage is taken by the small business groups. In case of small business the fixed cost of production plays an important role. On the other hand, in large companies’ debt equity ratio is a crucial factor. “Operating leverage is due to fixed operating costs associated with the production of goods and services where as the financial leverage is due to the existence of fixed financing cost. Both the types of leverage affect the level and variability of the firm’s after tax earnings and enhance the overall risk and return” (Wachowicz 414). Work Cited Akrani, Sameer. Concept of Cost Capital: Importance and Calculation. Kalyan City Life. 2011. Web. 03 Nov. 2011. Choi, Frederic D.S. International Finance and Accounting Handbook. 3rd Edn. Wiley. John Wiley & Sons, Inc. 2003. Web. 03 Nov. 2011. Helfert, Erich A. Financial Analysis: Tools and Techniques: A Guide for Managers. McGraw-Hill Companies. 2001. Web. 03 Nov. 2011. Jorgenson, Dale Weldeau. & Yun, Kun-Young. Investment: Lifting the Burden: Tax Reform, the Cost of Capital, and U.S. Economic Growth. United States of America. 2001. Web. 03 Nov. 2011. Unit 13L Leverage Analysis. Leverage Analysis. n.d. Web. 03 Nov. 2011. Wachowicz, John Martin. Fundamentals of Financial Management in the Year 2005. 2005. Print. Read More