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This document discusses cost of capital and leverages. It defines cost of capital as the average rate of return required by investors in a company. It also discusses the different types of costs of capital like cost of debt, equity, etc. It then explains the concept of leverages, specifically operating leverage which refers to the use of fixed costs, and financial leverage which means the use of fixed-charge sources of funding. It provides definitions and formulas for calculating weighted average cost of capital, degrees of operating and financial leverage, and combined leverage.
This document discusses cost of capital and leverages. It defines cost of capital as the average rate of return required by investors in a company. It also discusses the different types of costs of capital like cost of debt, equity, etc. It then explains the concept of leverages, specifically operating leverage which refers to the use of fixed costs, and financial leverage which means the use of fixed-charge sources of funding. It provides definitions and formulas for calculating weighted average cost of capital, degrees of operating and financial leverage, and combined leverage.
This document discusses cost of capital and leverages. It defines cost of capital as the average rate of return required by investors in a company. It also discusses the different types of costs of capital like cost of debt, equity, etc. It then explains the concept of leverages, specifically operating leverage which refers to the use of fixed costs, and financial leverage which means the use of fixed-charge sources of funding. It provides definitions and formulas for calculating weighted average cost of capital, degrees of operating and financial leverage, and combined leverage.
The return that an investor receives from a security is the cost of that security to the company that issues it.
It is the average rate of return required by the investors who provide capital to the company.
A companys cost of capital is the average cost of the various capital components (equity, preference, and debt) employed by it.
A firms cost of capital may also be defined as the rate of return the firm requires from investment in order to increase the value of the firm in the market place.
Importance of cost of capital
Capital budgeting decisions
Capital structure decisions
Types of cost of capital
Cost of debentures
Cost of preference shares
Cost of equity shares
Cost of retained earnings
Weighted average cost of capital
Once the component costs have been calculated, they are multiplied by the weights of the various sources of capital to obtain a weighted average cost of capital (WACC).
The following steps are involved in calculating WACC:
Calculate the cost of the specific sources of funds.
Multiply the cost of each source by its proportion in the capital structure.
Add the weighted component costs to get the firms WACC. Kw=K1W1+K2W2+K3W3+. Where K1,K2,K3are component cost
W1,W2,W3are weights of various types of capital employed.
Leverages
The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return may be termed as leverage.
There are two types of leverages Operating leverage Financial leverage
The leverage associated with investment (asset acquisition) activities is referred to as operating leverage, while leverage associated with financing activities is called financial leverage.
Operating leverage
Operating leverage refers to the use of fixed costs in the operations of the firm.
Operating leverage results from the existence of fixed operating expense in the firms income stream. A firm will have no operating leverage if the ratio of fixed costs and variable cost is nil. For such a firm, a given change in sales would produce the same percentage of change in operating profits.
If a firm has fixed cost, it would have operating leverage and with the change in sales, the percentage change in profit will be more. Operating profits of a highly leveraged firm would increase at a faster rate for any given increase in sales.
However, if the sale falls, a firm with a higher operating leverage would suffer more loss than a firm with no or low operating leverage. Operating leverage is a double edged sword.
It can be defined as the firms ability to use fixed operating costs to magnify the effect of change in sales on its earning before interest and taxes.
Degree of operating leverage
It can be defined as the percentage change in operating profits resulting from a percentage changes in sales. Thus: DOL=%Change in operating profit %Change in sales
Financial leverage
The use of fixed charges sources of funds, such as debt and preference capital along with the owners equity in the capital structure, is described as financial leverage.
The financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. Financial leverage at once provides the potentials of increasing the shareholders earnings as well as creating the risks of loss to them. it is a double edged sword.
The financial leverage will have a favorable impact on EPS only when the firms return on investment (ROI) exceeds the fixed cost of debt (i). The impact will be unfavorable if the ROI is less than the interest cost.
If the ROI is equal to the cost of debt than there is no effect of financial leverage on EPS.
Effect of leverage Favorable ROI>i Unfavorable ROI<i Neutral ROI=i
Degree of financial leverage
When the economic conditions are good and the firms EBIT is increasing, its EPS increases faster with more debt in the capital structure. The degree of financial leverage is defined as the percentage change in EPS due to a given percentage change in EBIT.
DFL=%Change in EPS % Change in EBIT
Combined/Composite leverage It expresses the relationship between quantity produced and sold and EPS.
In other words, the effect of combining financial and operating leverages is a two- step magnification of any change in sales into a relative change in earning per share. DCL=DOL DFL