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Difference between operating and financial leverages

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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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. ...

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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