The Cost of Capital; Financial Leverage; Which Counts Most Term Paper

The Cost of Capital; Financial Leverage; Which Counts Most - Term Paper Example The high sale will result in higher profits and a reduction in variable costs signifies that the organization does not have to incur any extra expenses for each unit sold. An increased volume of sales will enable to company to save gain benefits from its fixed costs. The idea of operating leverage was initially developed for utilizing in capital budgeting. Operating leverage is a significant concept as it affects how responsive profits are to transforms into sales volume. â€Å"The Degree of Operating leverage is a function of the cost structure of a firm and is usually defined in terms of the relationship between fixed cost and total costs. A firm that has high fixed costs relative to total costs is said to have operating leverage. A firm with high operating leverage will also have higher variability in operating income than would a firm producing a similar product with low operating leverage† (Choi 20). Other things remaining the same, the high difference in operating income will guide to a high beta for the industry with higher operating leverage. It is helpful to recognize how operating profit will vary with a given change in units formed; operating leverage is helpful to decide the business risks. Operating leverage can also be understood as the degree to which an organization utilizes fixed costs in creating its goods or offering its facilities. A fixed cost contains advertising expenses, equipment and technology, administrative costs, taxes, and depreciation. However, it excludes interest on debt, which is an element of financial leverage. By using fixed production costs, an organization can raise its earnings. If an organization has a high amount of fixed costs, it has a high level of operating leverage. High-tech and automated companies, airlines, utility companies etc commonly have high amounts of operating leverage. The difference between variable and fixed costs is an old idea. This separation of costs by behavior is the basis for breakeven a nalysis. â€Å"The idea of â€Å"break even analysis† is based on the simple question of how many units of product or service a business must sell in order to cover its fixed costs before beginning to make a profit. Presumably, unit prices are set at a level high enough to recoup all direct unit costs and leave a margin of contribution toward fixed cost and profit† (Helfert 193). Once adequate units have been sold to accrue the total contribution required to offset every fixed costs, the margin from any extra units sold will become revenue unless a latest layer of fixed expenses has to be added at any future point to support the high volume. Understanding this attitude will enhance the insight into how operational features of a business involve the elements of financial projections and planning. This information is also useful in setting operational strategies, which, particularly in an unstable business setting might, for instance, focus on reducing fixed costs during outsourcing certain operations. Cost of Capital: The cost of capital means the required rate of return for making capital budgeting. Cost of capital comprises the cost of debt and the cost of equity acquired through different sources. Cost of capital is the average rate of return required by the investors for their long term investments such as equity fund, preference fund and long term capital. When the firm makes long term investm