Glimore

Operating leverage is important because of its impact on the risk of the investment. However, a firm’s choice of operating leverage is limited by the number of possible different methods of producing a product or service. In some cases, a firm has little or no choice because there is a single (or most efficient) method of production. There are two important things to remember about operating leverage. First, operating leverage is generally unique for each investment rather than identical for all of the firm’s investments. Second, operating leverage affects the total risk of the capital budgeting project, both diversifiable and nondiversifiable risk. Therefore, it also affects both the project’s beta and its cost of capital. Financial Leverage Operating risk depends principally on the nature of the investment, and to a lesser extent on the firm’s choice of operating leverage. In contrast, financial risk depends mostly on financial leverage. When a firm has some debt financing, that portion of its financing costs is fixed rather than variable. Although we would expect a larger return to shareholders than to debtholders, shareholder return can vary from one period to the next without affecting the operation of the firm. However, failure to make required debt payments can result in bankruptcy. We could say, then, that financial leverage substitutes fixed payments to debtholders for variable payments to shareholders. Graphically, financial leverage looks a lot like operating leverage. The realized return to the shareholders (owners) in an all-equity-financed firm is the same as the realized return to the firm. The realized return to the shareholders in a leveraged firm is the realized return after the fixed payment to the debtholders has been taken out. The shareholders are the residual owners. Figure 8-3 illustrates the shareholders’ realized return as a function of the firm’s realized return with and without leverage. The leverage alternative assumes 50% debt financing. Figure 8-3 ignores taxes and assumes the firm pays a 10% interest rate on its debt. Figure 8-3 Illustration of the effect of (financial) leverage on shareholder return. [Click to enlarge] We have come across the concept of financial leverage before. Recall that investors in a perfect capital market should all invest in the same risky portfolio—the market portfolio. Investors set their risk and return levels by lending or borrowing. This kind of lending and borrowing is simply personal financial leverage. There is a very important fact we learned about personal leverage: The choice of lending or borrowing (personal financial leverage) does not alter the total value of an investment. It is just like our example of a pure risk-return trade-off. Any change in the expected cash flows is exactly offset by a change in risk and required return. So the choice of personal leverage is yet another pure risk-return trade-off. It is the investor’s choice of personal capital structure that puts the investor at a particular point on the capital market line (CML). This same conclusion holds for a firm’s choice of capital structure in a perfect capital market environment. Financial leverage is not a matter of value. It is a question of risk-return preference, subject to a market-determined risk-return trade-off. Financial leverage has three important corresponding (and almost opposite to those for operating leverage) things to remember about it. First, a firm’s choice of leverage is for the most part made for the entire firm rather than separately for each of the firm’s investments. Second, leverage affects the risk borne by each class of investor (debt, equity, and so on), but it does not affect the cost of capital for the investment in a perfect capital market environment. Third, within a very wide range, a firm can choose its amount of leverage.