Financial leverage reflects the degree to which a company has debt in its capital structure. The more debt is in the capital structure, the higher the leverage of the company. The reason is that with more debt, the company's financial risk is higher. It must pay out more of its earnings to the creditors, increasing the risk that there is nothing left for shareholders. However, of what is left, it is spread among fewer shareholders. As a result, a company that is highly profitable will return tremendously to shareholders. The returns to shareholders (ROE) are much more volatile the higher the degree of financial leverage a company has. If a firm uses preferred stock in its capital structure, that is still financial leverage. Preferred stock dividends do not typically change, so preferred stock does usually create and maintain an obligation to those shareholders, even if preferred stock is subordinated to debt.
Operating leverage reflects the degree of fixed to variable costs in a business. Fixed costs are the operating equivalent of debt, as they are costs that will be incurred no matter what happens...
So in periods of low demand, the company is at significant risk of losing money, whereas if demand is high, once the fixed costs are covered the company will turn considerable profits. If a firm uses operating leverage, this creates a situation where the firm needs to focus on driving revenue as much as possible, to cover the fixed costs, because until they are covered the firm will not be profitable, but once they are it can shift to being profitable quite quickly.
Combined leverage is the combination of operating and financial leverage. There is sometimes a relationship between these different types of leverage. One principle with respect to financing is that fixed assets with a specific life span should be financed with debt that matches that life span. Thus, a company with a large amount of fixed assets (high operating leverage) might also have a high amount of financial leverage. An example of this would be an airline, which either buys aircraft with financing, or it has long-term leases on aircraft. In either case, the fixed asset is financed via a debt obligation, providing both a high level of operating and financial leverage. A software company would be the opposite. A software company has relatively few fixed costs, and may be financed…
Capital Structure Modigliani and Miller argued that capital structure is irrelevant, all other things being equal, but in the real world those other things are never equal. The factors that are ruled out of MM are neutral taxes, no capital market frictions, symmetric access to credit markets, and that firm finance policy reveals no information. Normally, arguments against the irrelevance of capital structure are based on these factors that MM assumed
Capital Structure Decision and Cost of Capital In basic terms, capital structure has got to do with how companies finance their overall operations using various sources of funds. In this text, I recommend what is in my opinion the optimal capital structure for the three companies selected for purposes of this discussion. The companies that will be used for purposes of this discussion are: Alaska Air Group, the Clorox Group, and
Capital Structure and the Dividend Policies Investment in firms Miller-Modigliani Theorem Impact of taxes Impacts of bankruptcy Dividend Signaling Clientele effect The general principles for investment are applicable to every business and these may be outlined simply through saying the one should invest in projects that provide greater yields than the basic minimum acceptable rate. The rate is naturally to be dependent on the risk involved in the project. It should also reflect the basic financing mix
All theories of capital structure are considered supplementary. As Myers pointed out it is a 'kind of puzzle and every new theory fills a small gap'. (Does Capital Structure really matter?) Evaluating the tradeoff and pecking order theory Shyam-Sunder and Myers by analyzing the debt patterns through time they could find out that under the pecking order model, "a regression of debt financing on the firms deficit of funds should
Introduction Corporate finance focuses on financial decisions made by financial managers. Financial decisions is broadly categorized into two: financing decisions and investment decisions (Renzetti, 2001). Investment decisions determines the composition of assets held by a firm while financing decisions focuses on the optimal mix of debts and equity (capital structure). An optimal capital structure can be defined as a combination of equity and debt that maximizes shareholders’ wealth or value of
5x -- 50,000 200,000 / 7.5 = 26,6667 units 1e) the ROE for the first scenario is 140,000 / (0.85*350,000) = 47% the ROE for the second scenario is 140,000 / (0.65*350,000) = 61.5% The difference is 61.5 -- 47 = 14.5% 1f) the dividend payout structure is going to be as follows. The taxable income will be as follows: ($200,000 * .35) = $70,000 of debt. The interest will be (70,000)(.105) = $7,350 So taxable income