Analyses for Financial Management - Chapter 6

What is operating leverage? How, if at all, is it similar to financial leverage? If a firm has high operating leverage, would you expect it to have high or low financial leverage? Explain your reasoning.

Operating leverage may be termed as the ratio of the fixed and variable costs incurred by a firm or a project. Usually for operating leverage in a company, fixed costs are more than the variable costs. Operating leverage requires an increase in operating income such as more sales is essential in order to cover fixed financial costs, but when the breakeven is achieved, profits rise swiftly with the additional sales. If a firm has a high operating leverage, then it would be better for that firm to have a low financial leverage. Having a high operating as well as financial leverage would be very risky for the firm's equity, since in both the cases the fixed costs of the firm would be increased.

Explain how a company can incur costs of financial distress without ever going bankrupt. What is the nature of these costs?

Costs of financial distress are costs that are incurred by a company when it uses too much debt. As a result, the firm may face difficulty to pay off its obligations to its creditors and may incur additional costs. Sometimes these distress costs are higher than the cost of bankruptcy and may occur even if the company does not go bankrupt. Distress costs can be in the form of:

* Bankruptcy costs- Costs to the firm when the firm goes bankrupt. Bankruptcy cost is high if the company has more intangible assets and vice-versa.

* Indirect costs- Indirect costs increases as the probability of the firm to go bankrupt increases. Indirect costs are such as, increase in costs as suppliers become unwilling to provide trade credits doubting the ability of the firm to repay them, decreases in sales as buyers doubt the firm's capability of providing long-term service commitments, lost profit as management decides to cut back investments, R & D, marketing in order to save cash and price wars by competitors

* Costs occurred when there is a conflict of interest- The management may have a conflict of interest during a financial distress. These conflicts may cause a firm to over finance its debt, thus increasing its financial burden and the risk of bankruptcy.

Why might it make sense for a mature, slow-growth company to have a high debt ratio?

It may make sense for a mature, slow-growth company to have a high debt ratio since:

* It may be cost effect for a slow-growth company to have a high debt ratio as the cost of debts is low for such companies.

* A high debt ratio may place a regulation on the company and a burden to increase the operating and management efficiency