Question

According to a Chief Financial Officer of a listed company, she thinks that financial leverage is more effective than operating leverage in the real world as one can use financial derivatives to manage the risk accordingly. Do you agree with her? (Not more than 750 words) [15 marks]

Answer 1

A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than the actual, this could lead to a huge discrepancy between actual and budgeted cash flow, which will have a significant effect on a firm's future operating ability.

The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.

so a firm that operate on high financial leverage is more risky also she can used derivatives to hedge the risk but the managed risk throuh heding also comes at a cost also this cost would be higher because company's equity is diminished because of high financial leverage aalso the profitibility can be diminished if there is error in forecasting and if company continue to operate in long run then company return will be zero