FINANCIAL MANAGEMENT

ASSIGNMENT-2

SUBMITTED BY
Amrutha Sajeev [FM-1951]
Alen Augustine [FM-1952]
Anu Krishnan [FM-1953]
Chithralekha S Kumar [FM-1950]
Abhirami Vijay [FM-1955]
INTRODUCTION

In finance, leverage is a strategy that companies use to increase assets, cash flows, and
returns, though it can also magnify losses. Leverage results from using borrowed capital as a
funding source when investing to expand the firm's asset base and generate returns on risk
capital. Leverage is an investment strategy of using borrowed money specifically, the use of
various financial instruments or borrowed capital to increase the potential return of an
investment. Investors use leverage to multiply their buying power in the market. Companies
use leverage to finance their assets instead of issuing stock to raise capital, companies can use
debt to invest in business operations in an attempt to increase shareholder value.
In short, the term ‘leverage’ is used to describe the ability of a firm to use fixed cost assets or
funds to increase the return to its equity shareholders. In other words, leverage is the
employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of
interest obligation—irrespective of the level of activities attained, or the level of operating
profit earned. Leverage occurs in varying degrees. The higher the degree of leverage, the
higher is the risk involved in meeting fixed payment obligations i.e., operating fixed costs
and cost of debt capital. But, at the same time, higher risk profile increases the possibility of
higher rate of return to the shareholders. There are two main types of leverage, financial and
operating. 

Financial Leverage

The use of borrowed money (debt) to fund the purchase of assets with the hope that the new
asset's income or capital gain will surpass the cost of borrowing is known as financial
leverage.

In most circumstances, the debt provider will set a limit on the amount of risk it is willing to
assume, as well as the amount of leverage it will allow. Asset-backed lending involves the
financial provider using the borrower's assets as collateral until the loan is repaid. In the event
of a cash flow loan, the company's overall creditworthiness is used to secure the loan.

Debt to Equity Ratio

The debt-to-equity ratio is used to determine the amount of financial leverage of an entity,
and it shows the proportion of debt to the company’s equity. It helps the company’s
management, lenders, shareholders, and other stakeholders understand the level of risk in the
company’s capital structure. It shows the likelihood of the borrowing entity facing difficulties
in meeting its debt obligations or if its levels of leverage are at healthy levels. The debt-to-
equity ratio is calculated as follows:

Advantages of Financial Leverage

Financial leverage has two primary advantages:

● Enhanced earnings. Financial leverage may allow an entity to earn a disproportionate

amount on its assets.

● Favourable tax treatment. In many tax jurisdictions, interest expense is tax deductible,
which reduces its net cost to the borrower.

Disadvantages of Financial Leverage

Financial leverage also presents the possibility of disproportionate losses, since the related
amount of interest expense may overwhelm the borrower if it does not earn sufficient returns
to offset the interest expense. This is a particular problem when interest rates rise or the
returns from assets decline.

Financial Leverage Examples

Companies can sell preferred stock to the public for a certain price. Let’s say Leverage, Inc.
sells 1,000 shares of preferred stock for 1 dollar each. The company can then invest this
$1,000 either in the stock market or in new capital for the business operations. Let’s assume
the $1,000 was reinvested at a rate of 10 percent. At the end of the year, the company issues a
5-cent dividend to each preferred shareholder. Leverage, Inc. is financially leveraging its
preferred stock issuance because the cost of maintaining the stock (the preferred stock
dividends) is less than the return on the capital received from the preferred shareholders.
Issuing preferred shares is only one form of financial leverage. Companies can also issue
debt, like bonds to finance investments.
The same financial leverage principle applies to debt just like preferred stock. As long as the
return on investments is greater than the interest paid on the issued bonds, the company will
have effectively leveraged their finances. The term financial leverage is also used to describe
the overall debt load of a company by comparing debt to assets or debt to equity. In a sense,
it’s a measure of how risky the company is. A highly leveraged company would have
a leverage ratio close to 1 or higher. These means that every dollar of assets or equity is
matched by one dollar of debt.
Example 1
Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to
make a 10% down payment and take a $450,000 mortgage for the rest of the payment
(mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today.
Who will realize a higher return on investment if they sell the house for $550,000 a year from
today? 

Although Jim makes a higher profit, Bob sees a much higher return on investment because he
made $27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with
a $500,000 investment).
Example 2
Using the same example above, Bob and Jim realize they can only sell the house for
$400,000 after a year. Who will see a greater loss on their investment?
 Now that the value of the house decreased, Bob will see a much higher percentage loss on
his investment (-245%), and a higher absolute dollar amount loss because of the cost of
financing. In this instance, leverage has resulted in an increased loss.

OPERATING LEVERAGE
Operating leverage is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high gross margin and low variable costs has high operating leverage. Operating
leverage is a cost-accounting metric that determines how much a company or project may
raise operating profitability by boosting revenue. Regardless of whether they sell any units of
product, companies with significant operational leverage must cover a bigger amount of fixed
costs each month. Low-operating-leverage enterprises may have high variable costs that are
directly proportional to revenues, but they have lower monthly fixed costs to cover. The
larger the degree of operating leverage, the greater the risk of forecasting risk, in which a
little inaccuracy in sales forecasting can result in substantial errors in cash flow forecasts. The
operating leverage method is used to determine a company's break-even point and to assist in
the determination of optimum selling prices to cover all costs and create a profit. The method
can demonstrate how successfully a corporation uses its fixed-cost assets to create revenues,
such as its warehouse and machinery and equipment. The more a company's operating
leverage is, the more profit it can extract out of the same amount of fixed assets. Companies
may learn one thing by looking at operating leverage: enterprises that reduce fixed expenses
can boost profits without changing the selling price, contribution margin, or number of units
they sell. Operating leverage, on the other hand, can be defined as a company's capacity to
utilise its fixed costs to generate higher returns.
Airline Sector Example

Salient features of the Airline Sector

 Higher Fixed Costs

 Lower Variable Costs (as compared to fixed costs)
 Due to the above, this sector should have high Leverages.

Below is the list of some of the Top Airline companies along with their DOLs for 2016-2017

CONCLUSION

In conclusion, leverages are a powerful tool for enhancing investment returns and acquiring
assets for both investors and businesses. It is, however, still a type of debt, and as such, it
carries a significant set of risks and restrictions. It is recommended that first-time investors
avoid using leverage in their investments because the risks are high and the returns are
always unpredictable. A company can use Leverage to increase its shareholders' wealth, but
in case it fails to do so, the interest expense and credit risk can destroy the shareholders' value
and interest expense must still be paid and can become problematic if there is not enough
revenue to meet debt and operational obligations.
Financial leverage is determined by the firm's financing choices, as opposed to operating
leverage, which is driven by the firm's choice of technology (fixed and variable expenses)
(the mix of debt and equity). The use of leverages, both financial and operational, should be
done with extreme caution and after comprehensive research in order to get the most out of
them and maximise the likelihood of creating positive returns.