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Difference between operating and financial leverages

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Discuss the difference between operating and financial leverage. Can there be too much financial leverage in a firm? Why or why not?

Which portion of the WACC calculation is impacted by taxes? How can a company reduce its cost of capital? How is WACC used in financial planning to optimize capital structure?

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Solution Summary

The difference between operating and financial leverage is discussed. Portion of the WACC calculation impacted by taxes is demonstrated. Reducing cost of capital of a company is explored. How WACC is used in financial planning to optimize capital structure is clarified.

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Financial leverage - Can there be too much financial leverage in a firm? Why or why not?
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Financial leverage is the use of debt to magnify return on equity to shareholders. Financial leverage is a risky strategy for financing: If your firm is too leveraged (too much debt) and it experiences a downturn in sales, it may be unable to pay the interest on its debt. As a result, excessive financial leverage is regarded as increasing the default risk of a firm.

Financial leverage is a two-edged sword: If sales and profits decline, return on equity drops sharply.

Operating leverage
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Operating leverage also magnifies the financial performance of a business. Instead of depending on the capital structure of the firm, however, operating leverage depends on its cost structure.

Operating leverage too, like financial leverage, is a two-edged sword. When sales are increasing, a cost structure that favors fixed costs results in a greater percentage increase in profits. When sales slump, a high fixed-cost structure eats up profits.

Since your decisions on how to finance a business are based, in part, on how much in fixed assets you invest in, you will want to evaluate the role of operating leverage. ...

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