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)

Answer 1

The effect of financial leverage or operating leverage depends on how much of leverage is being used and to at certain extent it is true that financial leverage can actually help the company in increasing its performance. The financial leverage can actually help the company in increasing its return on equity and reducing the weighted average cost of capital. Operating leverage is a measure of fixed cost. One thing to be considered is that leverage can help but excessive leverage can actually cause damage to the company, also know as distress cost. When there is excess debt in the capital structure, the interest cost increases and that also increase the cost of equity and further increasing the risk of default for the company on the interest payment. The derivatives on the other hand are tool that is used to manage risk but again derivative can be used to manage risk but when it is used for speculative purposes the risk increases because often the managers would underestimate the risk associated with the derivative position and overestimate the benefits associated but a careful approach to the use of derivatives can actually enhance the certainty in cash flow to the company, so it is true that financial leverage can actually help the company because in real world there are tax impact and the after tax cost of debt is usually less and so the weighted average cost of capital reduces but excess leverage can also increase the financial distress cost for the company causing default or bankruptcy.