corporate finance Flashcards
measures of leverage-
leverage
Leverage is the use of fixed costs in a company’s cost structure
Analysts refer to the use of fixed costs as leverage because fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses.
operating leverage
Fixed costs that are operating costs (such as depreciation or rent) create operating leverage
financial leverage
Fixed costs that are financial costs (such as interest expense) create financial leverage.
company’s use of leverage for three main reasons
- The degree of leverage is an important component in assessing a company’s risk and return characteristics
- Analysts may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals also helps the analyst evaluate the quality of management’s decisions
- the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage should help in forecasting cash flows and in selecting an appropriate discount rate for finding their present value.
leverage
Leverage increases the volatility(tendency to change quickly) of a company’s earnings and cash flows and increases the risk of lending to or owning a company
degree of leverage
the valuation of a company and its equity is affected by the degree of leverage:
The greater a company’s leverage, the greater its risk and, hence, the greater the discount rate that should be applied in its valuation. Further, highly leveraged (levered) companies have a greater chance of incurring significant losses during downturns, thus accelerating conditions that lead to financial distress and bankruptcy.
cost structure
The risk associated with future earnings and cash flows of a company are affected by the company’s cost structure.
The cost structure of a company is the mix of variable and fixed costs.
variable cost
Variable costs fluctuate with the level of production and sales.
Some examples of variable costs are the cost of goods purchased for resale, costs of materials or supplies, shipping charges, delivery charges, wages for hourly employees, sales commissions, and sales or production bonuses
fixed cost
Fixed costs are expenses that are the same regardless of the production and sales of the company. These costs include depreciation, rent, interest on debt, insurance, and wages for salaried employees.
Companies that have more fixed costs relative to variable costs in their cost structures have greater variation in net income as revenues fluctuate and, hence, more risk
business risk
Business risk is the risk associated with operating earnings. Operating earnings are risky because total revenues are risky, as are the costs of producing revenues. Revenues are affected by a large number of factors, including economic conditions, industry dynamics (including the actions of competitors), government regulation, and demographics. Therefore, prices of the company’s goods or services or the quantity of sales may be different from what is expected.
Business risk is therefore the combination of sales risk and operating risk. Companies that operate in the same line of business generally have similar business risk.
sales risk
The uncertainty with respect to the price and quantity of goods and services
operating risk
The risk attributed to the operating cost structure, in particular the use of fixed costs in operations; the risk arising from the mix of fixed and variable costs; the risk that a company’s operations may be severely affected by environmental, social, and governance risk factors.
Operating risk is the risk attributed to the operating cost structure, in particular the use of fixed costs in operations. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk
financial risk
Financial risk is the possibility of losing money on an investment or business venture. Some more common and distinct financial risks include credit risk, liquidity risk, and operational risk. Financial risk is a type of danger that can result in the loss of capital to interested parties.
elasticity
The percentage change in one variable for a percentage change in another variable; a general measure of how sensitive one variable is to a change in the value of another variable
Degree Of Operating Leverage
(DOL) The ratio of the percentage change in operating income to the percentage change in units sold; the sensitivity of operating income to changes in units sold.
a company’s DOL is dependent on the level of unit sales being considered.
DOL= Percentage change in operating income/
Percentage change in units sold
Operating income is revenue minus total operating costs (with variable and fixed cost components)
Operating income= [(Price per unit)(Number of units sold)]−[(Variable cost per unit)(Number of units sold)]−[Fixed operating costs]
to calculate a firm’s DOL for a particular level of unit sales ,Q, DOL is :
DOL= Q(P-V)/Q(P-V)-F
where Q is the number of units, P is the price per unit, V is the variable operating cost per unit, and F is the fixed operating cost. Therefore, P − V is the per unit contribution margin and Q(P − V) is the contribution margin
When to use which formula of DOL
If data of 2 companies is given then use formula 1 so we can compare data of first year to second otherwise use formula 2
per unit contribution margin
The amount that each unit sold contributes to covering fixed costs—that is, the difference between the price per unit and the variable cost per unit.
contribution margin
The amount available for fixed costs and profit after paying variable costs; revenue minus variable costs
operating risk
The greater the use of fixed, relative to variable, operating costs, the more sensitive operating income is to changes in units sold and, therefore, the more operating risk
financial risk
Financial risk is the risk associated with how a company finances its operations. If a company finances with debt, it is legally obligated to pay the amounts that make up its debts when due. By taking on fixed obligations, such as debt and long-term leases, the company increases its financial risk. If a company finances its business with common equity, generated either from operations (retained earnings) or from issuing new common shares, it does not incur fixed obligations. The more fixed-cost financial obligations (e.g., debt) incurred by the company, the greater its financial risk.
degree of financial leverage (DFL)
DFL=
Percentage change in net income / Percentage change in operating income
A company’s DFL is dependent on the level of operating income being considered.
DFL
DFL =[Q(P−V)−F]/[Q(P−V)−F−C]
DFL is not affected by the tax rate
DOL & DFL
The degree of operating leverage gives us an idea of the sensitivity of operating income to changes in revenues. And the degree of financial leverage gives us an idea of the sensitivity of net income to changes in operating income.
Degree of total leverage
DTL=Percentage change in net income/Percentage change in the number of units sold
DFL
DFL =Q(P−V)/Q(P−V)−F−C
breakeven point
The number of units produced and sold at which the company’s net income is zero (Revenues = Total cost); in the case of perfect competition, the quantity at which price, average revenue, and marginal revenue equal average total cost
breakeven point
QBE=F+C/P−V
operating breakeven point
The number of units produced and sold at which the company’s operating profit is zero (revenues = operating costs).
QOBE=F/P−V
reading 1 - corporate governance
Weak corporate governance is a common thread found in many company failures. Lack of proper oversight by the board of directors, inadequate protection for minority shareholders, and incentives at companies that promote excessive risk taking are just a few of the examples that can be problematic for a company. Poor corporate governance practices resulted in several high-profile accounting scandals and corporate bankruptcies over the past several decades
corporate governance
The system of internal controls and procedures by which individual companies are managed
It provides a framework that defines the rights, roles, and responsibilities of various groups within an organization. At its core, corporate governance is the arrangement of checks, balances, and incentives a company needs in order to minimize and manage the conflicting interests between insiders and external shareowners.”
corporate governance differs within countries
Corporate governance practices differ among countries and jurisdictions, and even within countries different corporate governance systems may co-exist. The corporate governance systems adopted in most of the world typically reflect the influences of either shareholder theory or stakeholder theory to a varying extent, as well as historical, cultural, legal, political, and other influences specific to a region
shareholder and stakeholder theory
Shareholder theory takes the view that the most important responsibility of a company’s managers is to maximize shareholder returns. Stakeholder theory broadens a company’s focus beyond the interests of only its shareholders to its customers, suppliers, employees, and others who have an interest in the company. The approach to corporate governance in a given country typically places greater emphasis on one of the two theories but can also exhibit a combination of the two. Notwithstanding the system of corporate governance used, nearly all companies depend on contributions from a number of stakeholders for their long-term success. The company’s strategy is set by the board of directors, which also oversees management. In turn, the company’s strategy is executed by its managers; financial capital to fund the company’s activities and operations is supplied by shareholders, creditors, and suppliers; human capital is provided by employees; and demand for goods and services comes from customers. Other stakeholders include governments and regulators, which seek to protect the interests and well-being of their citizens. Certain external forces, such as the legal environment and competition, affect the way a company operates and the relationships among its stakeholders.
