Business Administration - Accounting & Financial Planning FIN401 Lecture Notes - Lecture 18: Operating Leverage, Financial Risk, Fixed Cost

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greenmuskrat329

20 Jan 2018

School

Seneca College

Department

Business Administration - Accounting & Financial Planning

Course

Business Administration - Accounting & Financial Planning FIN401

Professor

Larry Hurst

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Document Summary

In the physical sciences as well as in politics, the term leverage has been popularized to mean the use of special force and effects to produce more than normal results from a given action. In business the same concept is applied- the use of fixed cost items in particular capital assets ( equipment etc) and debt to magnify shareholders return at high levels of operation. Leverage is the use of various financial instruments or borrowed capital to increase the potential return of an investment. It is also defined as the amount of debt used to finance a firm"s assets. A firm with significantly more debt than equity is considered to be highly leveraged. An example of leverage: the use of mortgage to purchase a home. Say for example you are buying a home for and you put down 20% and borrow the rest.

Related Questions

1. Your company pays interest on its 3 year, 6% coupon rate debt as follows: Year 1: $50 million Year 2: $40 million Year 3: $30 million The tax rate is 40%. What is the present value of the interest tax shield if the discount rate is 8%? 48 mil 41.76 mil 52.23 mil 32.18 mil

2. How does the interest deduction from taxes affect the conclusions of the MM Propositions? Firm value increases with leverage but WACC remains constant. Firm value decreases with leverage, and WACC is unaffected. Firm value decreases with leverage, and WACC inreases with leverage. Firm value increases with leverage and WACC decreases with leverage..

3.Which of the following is true about agency considerations in finding the optimal capital structure for a firm? No answer text provided. Outside equity costs more than debt, and debt costs more than retained earnings due to information asymmetry. Therefore, finance project with retained earnings first, debt second, and outside equity last. Through their control of management, stockholders will take more risk than what is in bondholders' interets. The optimal level of debt is determined by trading off the benefits of deducting interest from taxes and the costs of financial distress.

skyhedgehog100

WEEK 7

Leverage & Capital Structure

1) If a firm is highly leveraged (lots of debt...very high debt/equity ratio, for example), discuss the impact this has on the Income Statement and the shareholders.

2) Now discuss the opposite...little to no debt, but lots of equity. How does this impact the Income Statement and shareholders?

3) As a potential shareholder in any given firm, what capital structure would you prefer? Lots of debt or lots of equity?....Why?

4) What is your "Takeaway?"

salmonminnow552

Which of the following statements is most correct?

		If a firm is exposed to a high degree of business risk as a result of its high operating leverage, then it probably should offset this risk by using a larger-than-average amount of financial leverage. This follows because debt has a lower after-tax cost than equity.
		Financial risk can be reduced by replacing common equity with preferred stock.
		The Hamada equation specifies the effect of financial leverage on beta. It shows how increases in the debt/equity ratio lowers beta.
		In the textbook, it was stated that the capital structure that minimizes the WACC also maximizes the firmâs stock price and its total value, but generally not its expected EPS. One reason given for why debt is beneficial is that it shelters operating income from taxes, while it was stated that a disadvantage of excessive debt has to do with costs associated with bankruptcy and financial distress generally.
		All of the above statements are false.

Business Administration - Accounting & Financial Planning FIN401 Lecture Notes - Lecture 18: Operating Leverage, Financial Risk, Fixed Cost

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