What Does The Weighted Average Cost Of Capital Tell You Effective Leverage and Optimal Capital Structure

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Effective Leverage and Optimal Capital Structure

How do small businesses choose their capital structure? When is it appropriate for a small business to finance its operations with borrowed money? What is the nature and function of effective leverage in financial management? These questions are related to the optimal capital structure of a business – the right mix of debt and equity that maximizes investment returns and shareholder wealth and minimizes the cost of capital, together. Of course, effective use is essential to a good business strategy designed to maximize the company’s wealth-generating potential. In this series of articles on effective financial management, we will focus on the strategic questions of related financing and provide some guidelines. The main purpose of this article is to highlight the basic financial theory and industry practices of successful capital raising. For personalized financial management strategies, contact a qualified professional.

Please note that the amount of investment appropriate for each company will be significantly different based on overall industry dynamics, competitive market structure, life cycle stage industry and competitive position in the market. Indeed, as with most market indicators, the company’s specific leverage position is meaningful only as an indication of the expected value of the industry (roughly) and the generally accepted industry standards and best practices.

Types of leverage:

Financial leverage: Financial leverage is the ratio of EBIT / EBT-earnings before interest and taxes divided by earnings before taxes. When a company relies on borrowed money – the investment is created because the company places a financial obligation or interest on the borrowed money. A percentage change in operating income (EBIT) results in a larger change in net operating income (NI) and earnings per share. In fact, a small percentage change in operating income (EBIT) is multiplied into a larger percentage reduction in revenue. The level of financial leverage (DFL) measures the company’s exposure to financial risk or the sensitivity of EPS to changes in EBIT. Therefore, DFL indicates the percentage change in earnings per share (EPS) from the percentage change in earnings before interest and taxes (EBIT). In general, the need for short-term financing for the company is affected by the current growth of sales and the efficient and effective way of managing the working capital. now compared to current debt. Note that short-term financing needs may reflect long-term financing needs including evaluating the appropriate mix and use of debt and equity-capital structures.

Investments: Fixed business costs, such as general administrative expenses, contract employee wages, and loans or leases involve investments and often increase business risk. . The impact of operating leverage is evident when a percentage change in net sales results in a greater change in operating income (EBIT)—earnings before interest and taxes. Operating leverage is calculated as follows: DOL = CM/EBIT-contribution ratio divided by earnings before interest and taxes or percentage change in EBIT divided by percentage change in sales (money).

Combined Leverage: The level of combined leverage (DCL) is a combination of the product of business risk and financial risk. Degree of operating leverage (DOL) and degree of financial leverage (DFL) combine to increase the percentage change in sales for the greater percentage change in revenue or income. debt (EBIT). There is a direct relationship between the level of investment (DOL), financial investment (DFL) and cumulative leverage (DCL). Combined leverage (DCL) = DOL X DFL or CM/EBIT X EBIT/EBT which is CM/EBT. The level of combined leverage (DCL) can also be calculated by the percentage change in EPS divided by the percentage change in sales which is the percentage change in cash flow. income percentage from the percentage change in sales.

Optimal Capital Structure: This is the optimal use of debt and equity that reduces the company’s cost of capital and increases the stock price. Note that a poor management system or a lack of credit and the best mix can lead to higher financial costs and the company may reject some financing projects that could increase wealth ‘the responsible for the best funding. Additionally, the impact of different capital structures and different business risks is reflected in the company’s income statement. Note that operating expenses tend to increase the impact of changes in sales (revenues) and result in larger percentage changes in operating income (EBIT) than changes in sales (costs). if the investment increases the percentage change in EBIT and produces a greater percentage change in EPS. Therefore, changes in sales (earnings) affect EBIT. This change in EBIT through the impact of investments affects EPS.

Some helpful tips:

As a business grows, it needs capital which can be financed by cash or debt. Debt financing has its costs and benefits. Debt has two main advantages: the interest paid is tax-deductible, which reduces the cost of debt; and the debt has a fixed charge, so the stockholders do not have to share their income if the company is actually profitable. On the one hand, a high debt ratio indicates a higher risk and therefore a higher cost of capital; and if the company does not generate enough revenue to cover its costs, it must release the shortfall or face bankruptcy. Therefore, companies with fixed income and cash flow must limit the use of debt financing. Of course, effective cash management and investment is essential in a prudent and sound strategy designed to increase the company’s ability to generate wealth. In addition, strategic analysis, market analysis and financial analysis should be consistent and internally consistent. EBIT/EPS analysis allows companies to evaluate the effects of different capital structures on operating income and levels of business risk. Fluctuations in sales or revenue over time are a fundamental operational risk. Note that in the budget for a special project to increase the wealth of the owner, it is necessary to earn more than the cost of capital or the barrier rate.

In practice, companies tend to use a target financing structure – a mix of debt, preferred stock, and common equity that the company intends to raise needed funds. And since capital structure policy involves a strategic trade-off between risk and expected return, optimal capital structure policy must seek a wise and informed balance between risk and return. Companies must consider business risks, tax positions, financial flexibility and conservatism or aggressiveness in management. Although these factors are important in determining the target capital structure, operating conditions may cause the actual capital structure to differ from the optimal capital structure. Therefore, the target capital structure should be used as a guide to the optimal capital structure that minimizes the weighted average cost of capital (WACC) and maximizes shareholder wealth.

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