Saturday, January 1, 2011

(245)---FINANCIAL AND OPERATING LEVERAGE

Financial and Operating Leverage

Introduction

The capital budgeting of a firm, it has to decide the way in which the capital projects will be financed. Every time the firm makes an investment decision, it is the same time making a financing decision also. For example, a decision to build a new plant or to buy a new machine implies specific way of financing that project. Should a firm employ equity or debt or credit? What are implies of the debt-equity mix? What is an appropriate mix of debt and equity?


Capital Structure Defined

The assets of a company can be financed either by increasing the owners' claims or the creditors claims. The owners' claims increase when the firm raises funds by issuing ordinary shares or by retaining the earnings; the creditors' claims increase by borrowing. The various means of financing represent the financial structure of an enterprise. The left-hand side of the balance sheet represents the financial structure of a company. Traditionally, short-term borrowings are excluded from the list of methods of financing the firms capital expenditure, and therefore, the long-term claims are said to from the capital structure of the enterprise. The term capital structure is used to represent the proportionate relationship between debt and equity. Equity includes paid up share capital, share premium and reserves and surplus.


The financing or capital structure decisions is a significant managerial decision. It influences the shareholder's return and risk. Consequently, the market value of the share may be affected by the capital structure initially at the time of its promotion. Subsequently, whenever funds have to be raised to finance investments, a capital structure decision is involved. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. This decision will involve an analysis of the existing capital structure and the factors, which will govern the decision at present. The dividend decision, is, in a way, a financing decision. The company's policy to retain or distribute earnings affects the owners' claims. Shareholders' equity position is strengthened by retention of earnings. Thus, the dividend decision has a financing decision of the company may affect its debt-equity mix. The debt-equity mix has implications for the shareholders' earnings and risk, which in turn, will affect the cost of capital and the market value of the firm.


The management of a company should seek answers to the following questions while making the financing decision:

  • How should the investment project be financed?
  • Does the way in which the investment projects are financed matters?
  • How does financing affect the shareholders' risk, return and value?
  • Does there exist an optimum financing mix in terms of the maximum value of the firms shareholders?
  • Can be optimum financing mix be determined in practice for a company?
  • What fact ores in practice should a company consider in designing its financing policy?

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