Methods Operational and Financial Leverage

Document Type:Coursework

Subject Area:Finance

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With financing debt, without taking into the account if the charges of interest are from the line of credit or a line, the payment of the interest is based on the deductibility of the tax. Additionally, when the company makes payment timely, then the company will have established a positive history of payment and credit rating of the business increased. Up to a certain point, the investors will prefer to use financial debt. When it goes beyond a given point, the investor fears about the high financial debt of the company because of the default risk of the company. Operational leverage In the chosen company; Ford Motor Company, the analysis breakdown two types of capital costs of the company’s structure of the capital costs (Kregel, 1989). This includes variable costs and fixed costs. Therefore, the company operating cost is the fixed cost percentage that it possesses at this time. Hence this is the ratio of the costs that are fixed to the costs that are variable in the company. The company under study, it is indicated that it has a lot of fixed cost as com[pared to the costs that are variable , hence it makes the firm to operate at high leverage the firm employ a lot of the fixed costs hence its business are of the intensive capital organization. For instance, this capital intensive company of automobile manufacturing and assembly. The company has a massive equipment amount that is needed for the manufacturing of their products of automotive cars.

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During the economy slow down like in the last three months, few cars were bought by the people and at the same time, the company had to incur payment for the fixed costs of the housing of the plant and storage of the equipment, equipment depreciation and cost that are fixed related to the intensive capital of the company. In comparison to the company with others that are labour intensive ones, the leverage for the capital intensive company of automobile is found to be higher than that of the labour intensive company. Operation leverage thus in this organization it shows the small change that has occurred in sales of its volume of products that has resulted in a large change in Return on Invested Capital (ROIC) and EBIT). Thus this firm is sensitive to the sales changes and has affected its line at the bottom at faster rate Cost of Capital In the automobile company, the capital cost of its equity and debt funds or the rate of return required on the company’s securities that exists have been used in the evaluation of the project that can be initiated (Abdallah & Hussein, 2014).

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Also it has been used to minimize the investors return exceptions on the capital invested. By computation of the different sources of the finance in the company and weighing the proportionally, the cost of the capital is determined after balancing them to their capital structure designated use. The importance value of the being maximized, help the company to minimize the cost of capital. The valuation of the company’s sources is closely related to the capital structure of cost components. Using equity, debts and weighted average of the cost of the capital is computed and it is useful to this company in making decisions associated with capital budgeting. The weighted average cost of capital is used to determine the value of the current of flows of future. This has helped the company to ensure is getting the financing cost for operations.

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In the past, the company capital structure was not balancing because of the rate of earnings at that time was below while the capital cost was high. Therefore, the company suffered the fate of high risk. For this case, the investors of the company needed higher returns so that they can be financed. It also plays an important role because it of various implications of tax equity against debt and the effect it has on the company’s profit making. Therefore, the company must be wise and selective in borrowing to avoid the risk of falling into bankruptcy and financial distress. The company to understand its usage to finance the assets, the ratio of debt to equity is used. Furthermore, it helps the company to know how it can borrow and its shareholder's values.

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This ratio is the measuring of the financial leverage of the company calculated and dividing by the total shareholders’ equity of liabilities. From this capital structure, the projection of the ROE company to be between ranges of 15. as it lies with the pre-tax earnings of this company as illustrated below; When compared to the Ford Motor Company’s capital structure is re-structured as50% consist of the capital of debt and 50% capital for equity, it is found that the company ROE dramatically increases to the ranges of 27. to 42. as shown in the table below. The company’s performance can dramatically look good when financial leverage is used compared when only relying on the use of the financial equity capital as indicated in the table below. The other risk metric the Ford Motor employs to know its level of risk in financial leverage is the coverage ratio.

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It helps the company to have an indication of ability to have pretax operating income that is enough that can enable the company to offset its financial debt. Description of Factors in the Non-financial and Intangible Decision-Making Process • The sales standpoint: A company will show a relatively and high stability in its sales and in the position that is better when using financial leverage than when it has volatile and lower sales. • Risk of the business: the company with operation leverage that is less has the ability to make financial leverage that is high with extending the operation leverage that is high. • The growth of the company: company that grows faster relies on the financial leverage because they need more capital compared to the slow growing company. The ratio of the debt to equity of the company largely depends on operations of the company.

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For instance the case of the Ford Motor Company with capital intensive have the ratio of debt to equity of above 2 while other companies with labour intensive have a ratio of below 0. Therefore, for the selection of the company, the labour intensive is preferable because of low operational leverages is has and the financial operation of the company is low while the return tends to be high because of the market vastness. However, with the use of the financial leverage in automobile company helps the company to operate well and o have financial returns that are high, but risky when the returns are lower than the interest costs. References Abdallah, B.  Principles of corporate finance (11th ed. New York, NY: McGraw-Hill Irwin. Đurić Dragana, M. Some of the unanswered questions in finance.

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Panoeconomicus, Vol 53, Iss 2, Pp 223-230 (2006), (2), 223. Review Of Accounting Studies, 8(4), 531-560. Sullivan, T. Market Power, Profitability and Financial Leverage. The Journal of Finance, 29(5), 1407-1414. doi:10.

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