Impact of leverage in firm investment decision
PART-II
DATA ANALYSIS AND INTERPRETATION
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2.0 What is Leverage?
Leverage can be defined as the ability of a firm to use its fixed cost assets or funds to magnify the returns to shareholders.
According to J. F. Weston, Scott, Besley and E. F. Brigham, “Leverage is created when a firm has fixed cost associated either with its sales and production operation or with its financing characteristics.” Leverage in other sense is the degree to which an investor or business is utilizing borrowed money. The higher the degree of leverage, the higher the degree of risk and rate of return.
Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders’ return on their investment and often there is tax advantages associated with borrowing.
The objective of Financial Management is to maximize the wealth of organization and to magnify the returns to shareholders. Financing and investment decisions are very important in maximizing shareholder’s returns. The fixed cost assets or funds of a company play important role in maximizing EPS, ROE etc.
2.1 Classifications of Leverage:
Basically, leverages are classified into two types. But, it can be ultimately three types. These are:
1)
Operating Leverage
2)
Financial Leverage
3)
Total/Combined Leverage.
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2.2 Operating Leverage
Operating leverage may be defined as the firm’s ability to use fixed operating cost to magnify the effects of changes in sales on its operating profit or earnings before interest and taxes (EBIT).
Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs,
As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets.
Firm A
DATA ANALYSIS AND INTERPRETATION
6|Page
2.0 What is Leverage?
Leverage can be defined as the ability of a firm to use its fixed cost assets or funds to magnify the returns to shareholders.
According to J. F. Weston, Scott, Besley and E. F. Brigham, “Leverage is created when a firm has fixed cost associated either with its sales and production operation or with its financing characteristics.” Leverage in other sense is the degree to which an investor or business is utilizing borrowed money. The higher the degree of leverage, the higher the degree of risk and rate of return.
Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders’ return on their investment and often there is tax advantages associated with borrowing.
The objective of Financial Management is to maximize the wealth of organization and to magnify the returns to shareholders. Financing and investment decisions are very important in maximizing shareholder’s returns. The fixed cost assets or funds of a company play important role in maximizing EPS, ROE etc.
2.1 Classifications of Leverage:
Basically, leverages are classified into two types. But, it can be ultimately three types. These are:
1)
Operating Leverage
2)
Financial Leverage
3)
Total/Combined Leverage.
7|Page
2.2 Operating Leverage
Operating leverage may be defined as the firm’s ability to use fixed operating cost to magnify the effects of changes in sales on its operating profit or earnings before interest and taxes (EBIT).
Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses, administrative costs,
As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets.
Firm A