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

Comments (0) Cite this document
Summary
Subject November 03, 2011 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…
Download full paperFile format: .doc, available for editing
GRAB THE BEST PAPER96% of users find it useful
The Cost of Capital; Financial Leverage; Which Counts Most
Read TextPreview

Extract of sample "The Cost of Capital; Financial Leverage; Which Counts Most"

Download file to see previous pages 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 investm ...Download file to see next pagesRead More
Cite this document
  • APA
  • MLA
  • CHICAGO
(“The Cost of Capital; Financial Leverage; Which Counts Most Term Paper”, n.d.)
The Cost of Capital; Financial Leverage; Which Counts Most Term Paper. Retrieved from https://studentshare.org/business/1435527-operating-leverage-the-cost-of-capital-financial
(The Cost of Capital; Financial Leverage; Which Counts Most Term Paper)
The Cost of Capital; Financial Leverage; Which Counts Most Term Paper. https://studentshare.org/business/1435527-operating-leverage-the-cost-of-capital-financial.
“The Cost of Capital; Financial Leverage; Which Counts Most Term Paper”, n.d. https://studentshare.org/business/1435527-operating-leverage-the-cost-of-capital-financial.
  • Cited: 0 times
Comments (0)
Click to create a comment or rate a document

CHECK THESE SAMPLES OF The Cost of Capital; Financial Leverage; Which Counts Most

International Cost of capital

...it for the purpose of knowing their current level of paying a cost of capital. With the help of weighted average of cost of capital, different projects can be evaluated and the most appropriate and lucrative profit would be ranked and selected with the help of weighted average of cost of capital. Since these are the most important benefits involving the use of weighted average of cost of capital for the international firms, large and big corporations prefer the use of weighted average of cost of capital. References 1. Megginson WL 1996,...
7 Pages(1750 words)Assignment

The cost of capital

...is faced with the financial question whether the assets can be better used in other areas or by fresh management. Brealey (2001) insists the managers can comment “I think I can understand a little of our shareholders’ worries,” the financial manager replies. “Just look at our return on assets. It’s only 6 percent, well below the cost of capital. Sure we are making a profit, but that profit does not cover the cost of the funds that investors provide. Our economic value added is actually negative. Of course, this doesn’t necessarily mean that the assets could be used better elsewhere, but we should certainly be looking carefully at whether any of our...
3 Pages(750 words)Essay

Cost of Capital

...complements each other’s capabilities in terms of investment opportunities and cash flows. A firm with low investment opportunities can maintain high cash flows, while on the other hand a firm can have more investment opportunities than the level of cash available for investments. According to Ray (2010), the merged firm “can lower the cost of capital due to the low cost of internal funds resulting from lowering risk, savings in floating cost and improving capital allocation” (Ray, 2010, p.338). Thus, financial competency can occur from reducing of cost of internal financing in relation to the external financing. A firm...
38 Pages(9500 words)Dissertation

Capital Structure and Leverage Practices

...and has specifically reported an 8% increase in dividends at the start of 2009. Recently, Family Dollar Company was reported to make a presentation "to the investment community at Barclays Capital Retail and Restaurants Conference" (Family Dollar). ANALYSIS OF THE COMPANY'S CAPITAL STRUCTURE AND LEVERAGE The capital structure of the company is heavy on stock issuance rather than on financial leverage through debts. Meaning, it sources its capital from its potential owners: the stockholders, although it has also tapped the Deutsche Bank this year as a potential creditor. The best strategies in capital...
4 Pages(1000 words)Essay

Financial Leverage

...to determine how well it is managing its debt position (Kim, , Lewellen and McConnell, 86) FINANCIAL LEVERAGE RATIOS: Financial leverage ratios consist of the following important ratios: Debt ratio Equity Ratio Debt-to-equity Ratio Interest coverage ratio Fixed charge coverage ratio Financial leverageCapitalization ratio Asset coverage ratio 1. DEFINITION OF DEBT RATIO: Debt ratio is the ratio that measures the claim of creditors on total assets. It also indicates the amount invested by the creditors in total assets of the firm. It shows how much assets were funded through creditors long and short-terms or...
9 Pages(2250 words)Essay

Cost of Capital

...an annual rate of return of 10.212% if the bond is held until its maturity in 10 years. Note: this calculation assumes that the coupon payments will be reinvested at the entered coupon rate. The risk-free return on investments (5%) is lower than the annual rate of return (10.212%) calculated above meaning that bonds offer investors an advantage over investments with risk-free return of 5%. Conclusion A critical analysis reveals that bonds present a big opportunity for non-profit hospitals to raise capital and for investors to earn returns. With the increasing cost of financing health care, leveraging on the bond market could reduce overall costs incurred by hospitals....
2 Pages(500 words)Essay

The cost of capital

...that the projects the firm undertakes are profitable. Another problem which may appear by considering the cost of new debt as the hurdle rate is the difficulty of quantifying this cost because debt is often not traded, and also yield to maturity is not available because there is no market price for the debt. Moreover, in the case of bank loans, the interest rates may be subject to reconsiderations over the life of the new investment due to changes in firm’s financial statements or general deterioration of its financial condition. So, it would not be in the interest of shareholders to not take into account all this issues when considering capital...
3 Pages(750 words)Assignment

DiscussionAnalyzing Cost of Capital

...certificates, advertising costs etc. For debt there are legal fees, valuation costs (i.e. security, audit fees, Bankers commission etc.). The company needs to determine the combination of capital items that will minimize to a large extent the marginal cost of capital (M.C.C). The company also needs to consider leverage. This is the amount of debt used to finance a firm’s assets. A firm with significantly more debt than equity is considered to be more leveraged. A high degree of leverage increases the financial risk the company faces, as it may not be able to refinance such debt,...
1 Pages(250 words)Essay

Leverage and capital structure chapter 13 solutions

...in high cost of capital, thereby lowering the NPVs of projects. On the other hand, effective capital structure decisions can lower the cost of capital leading to higher NPVs thereby increasing the value of the firm. All the items on the right hand side of the balance sheet, excluding current liabilities are sources of capital. Financial Risk The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. The more debt and preferred stock a firm has in its capital...
4 Pages(1000 words)Essay

Cost of Capital

... earnings is a component of the cost of equity. However, it excludes the taxes as well as the transaction costs associated with dividends making it slightly less than the common stock (Brigham & Houston, 2015). The cost of retained earnings should be at least equal to the shareholders’ rate of return on the re-investment of the company’s dividends. References Brigham, E., & Houston, J. (2015). Fundamentals of Financial Management. Boston: Cengage Learning. Rosenbaum, J, & Pearl, J. (2009). Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons.... Cost of Capital s Cost of Capital The cost of...
1 Pages(250 words)Coursework
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.

Let us find you another Term Paper on topic The Cost of Capital; Financial Leverage; Which Counts Most for FREE!

Contact Us