A Project Will Produce An Operating Cash Flow Of Effective Leverage and Optimal Capital Structure

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Effective Leverage and Optimal Capital Structure

How do small firms choose their capital structure? When is it appropriate for a small business to fund its operations with borrowed funds? What is the nature and function of effective leverage in financial management? These questions concern the optimal capital structure of a business venture—the right mix of debt and equity that maximizes return on investment and shareholder wealth while simultaneously minimizing the cost of capital. Clearly, a sound business strategy designed to maximize an enterprise’s wealth generation potential requires effective leverage. In this series on effective financial management, we’ll focus on pertinent financing strategy questions and provide some guidance. The main objective of this article is to highlight some basic financial theories and business practices in effective financial leverage. Please consult a competent professional for specific financial management strategies.

Please note that the appropriate amount of financial leverage for each firm varies markedly based on overall industry growth, market structure—level of competition, stage of the industry life cycle, and competitive conditions in the market. Indeed, like most market indicators, firm-specific leverage positions are only intuitive with respect to industry expected value (average) and generally accepted industry benchmarks and best practices.

Types of Benefit:

Financial Leverage: The degree of financial leverage is EBIT/EBT-the ratio of earnings before interest and taxes divided by earnings before interest and taxes. When a business relies on borrowed funds for its operations – financial leverage is created because the business has fixed financial obligations or interest on borrowed funds. A given percentage change in a firm’s operating income (EBIT) results in a larger percentage change in a firm’s net income (NI) and earnings per share. Indeed, a small percentage change in operating income (EBIT) is amplified into a large percentage decrease in net income. The degree of financial leverage (DFL) measures a company’s exposure to financial risk or the sensitivity of earnings per share (EPS) to changes in EBIT. Therefore, DFL represents the percentage change in earnings per share (EPS) that results from a unit percentage change in earnings before interest and taxes (EBIT). In general, a firm’s short-term financing needs are affected by current sales growth and how effectively and efficiently the firm manages its net working capital—current assets minus current liabilities. Note that ongoing short-term financing needs may reflect the need for permanent long-term financing with an appropriate mix of debt and equity-capital structures and assessment of utilization.

Operating leverage: Fixed operating expenses, such as general administrative overhead costs, contract employee salaries, and mortgage or lease payments create operating leverage and increase business risk. The effect of operating leverage is evident when a given percentage change in net sales causes a greater percentage change in operating income (EBIT)—earnings before interest and taxes. Operating leverage is calculated as follows: DOL = CM/EBIT-contribution margin divided by earnings before interest and taxes or percentage of EBIT divided by percentage change in sales (revenue).

Combined Leverage: Degree of Combined Leverage (DCL) is the combination of the effects of business risk and financial risk. The degree of operating leverage (DOL) and the degree of financial leverage (DFL) together measure the potentially greater percentage change in earnings or operating income (EBIT) from a given percentage change in sales. There is a direct relationship between the degrees of operating leverage (DOL), financial leverage (DFL) and consolidated leverage (DCL). Firm’s Degree of Combined Leverage (DCL) = DOL X DFL or CM/EBIT X EBIT/EBT means CM/EBT. The degree of consolidated leverage (DCL) can also be measured as the percentage change in EPS divided by the percentage change in sales i.e. the percentage change in earnings per share due to a unit percentage change in sales volume.

Optimal capital structure: It is the appropriate use of debt and equity that minimizes the company’s cost of capital and maximizes the stock price. Please note that a suboptimal capital structure or lack of an optimal debt and equity mix may lead to higher financing costs and the firm may reject some capital budgeting projects that would have increased shareholder wealth with optimal financing. Further, the effects of different capital structures and different degrees of business risk are reflected in the firm’s income statement. Please note that operating leverage increases the effect of fluctuating sales (revenues) and produces a percentage change in operating income (EBIT) rather than a change in sales (revenues), while financial leverage increases and produces a percentage change in EBIT. A large percentage change in EPS. Therefore, a change in sales (revenue) through operating leverage affects EBIT. This change in EBIT then affects EPS through the effect of financial leverage.

Some useful guidelines:

When a firm grows it needs capital which can be financed through equity or debt. Debt financing has costs and benefits. Loans have two significant advantages: the interest paid is tax deductible, which reduces the effective cost of the loan; And the debt carries a fixed fee, so if the enterprise is highly profitable, stockholders don’t have to share their net income. On the other hand, a high debt ratio indicates a high risk and therefore a high cost of capital; And if the firm fails to earn enough income to pay fixed charges, it must create a deficit or face bankruptcy. Therefore, companies with volatile earnings and operating cash flows must limit their use of debt financing. Certainly, effective cash flow and profitability management is critical to a prudent and sound strategy designed to maximize enterprise asset productivity. In addition, strategic analysis, market analysis and financial analysis should be internally consistent and coherent. EBIT/EPS analysis allows a firm to assess the effects of different capital structures on operating income and the level of business risk. Variability of sales or earnings over time is a fundamental operating risk. Please note that the capital budget for a particular project must earn more than its cost of capital or hurdle rate to maximize shareholder wealth.

In practice, companies use a target capital structure – a mix of debt, preferred stock and common equity with which the enterprise plans to raise the necessary funds. And since capital structure strategy involves a strategic trade-off between risk and expected return, an optimal capital structure strategy must seek a prudent and informed balance between risk and return. A firm must consider its business risk, tax position, financial flexibility and managerial conservatism or aggressiveness. Although these factors are important in determining the target capital structure, the actual capital structure may differ markedly from the optimal capital structure due to operating conditions. Therefore, the target capital structure should be used as a guide to an ideal capital structure that minimizes the weighted average cost of capital (WACC) while maximizing shareholder wealth.

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