Question

What is the difference between a 'debenture' Bond and a 'mortgage' Bond?

What is ‘Operating’ Leverage?

What is ‘Financial’ Leverage?

What is the relationship of leverage to risk?

What is the preferred order for corporations obtaning long term financing?

What is corporate ‘internal’ financing?  

Answer 1

1)      Difference between Mortgage Bond & Debenture Bond

A mortgage bond is secured, while a debenture bond is unsecured. Bonds offer some protection against the volatility and risk of stocks. Unlike stocks, investing in a bond makes you a creditor of the bond issuer, and you’ll have a high ranking claim on assets if the issuer defaults on the bond’s payment terms. Bonds fall into two categories: secured and unsecured. A mortgage bond is a type of secured bond; a debenture bond is also referred to as an unsecured bond.

A mortgage bond is a type of secured bond because the bond is backed by collateral. The collateral is usually real estate or some other type of property that is subject to a mortgage. In the event of a bond default, you can foreclose and sell the property tied to the bond to collect your investment. Due to their direct claim on company assets, a mortgage bond is a safer and higher quality investment with a lower risk of default than a debenture bond.

A debenture, or unsecured, bond is not backed by property. The bond issuer’s credit standing supports the promise that the bond’s payment terms will be met. Debenture bonds are issued when a company does not have enough assets to serve as collateral. If a company is well established and has a high credit rating, issuing debenture bonds is an easy way for them to raise funds. Debenture bonds typically carry more risk than mortgage bonds and must pay a higher interest rate to investors. If a company liquidates, debenture bondholders are paid after mortgage bondholders.

1. Operating Leverage

Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

Operating Leverage = Contribution Margin / Net Operating Income

1. Financial Leverage

Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share.

Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.

Degree of Financial Leverage
The formula for calculating a company's degree of financial leverage (DFL) measures the percentage change in earnings per share over the percentage change in EBIT. DFL is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.

Formula:

DFL = percentage change in EPS or EBIT
           percentage change in EBIT EBIT-interest

4) Relationship between Leverage and Business Risk

The risk of a firm is influenced by the use of leverage. Incurrence of fixed operating costs in the firm’s income stream increases the business risk or operating risk. It increases the variability of operating income due to change in sales revenue.

Similarly, employment of debt in the capital structure increases the financial risk. It increases the variability of the returns to the shareholders. So leverage and risk are directly related.

Leverage and Operating Risk:

Operating risk is the risk associated with the operation of the firm. It is a function of the operating condi­tions faced by a firm and the variability these conditions inject into the operating income and expected dividends. It arises out of the expected return on the total fund invested. Rate of return is a random vari­able as it takes different values at different points of time. This return varies from the expected return and this variation leads to rise in business risk. As leverage magnifies this variation resulting into larger fluctuations in operating income it is associated with operating risk.

Leverage and Financial Risk:

Financial risk is the risk associated with financing decisions of the firm. It is a function of the financial planning of the firm. If a firm increases the proportion of debt capital in its capital structure, fixed charges increase.

All other things being the same, the probability of the firm not being able to meet these fixed charges also increase. If the firm continues to lever itself, the probability of cash insolvency increases. Hence any decision to use debt or preferred stock in the capital structure of the firm means that the equity shareholders of the firm are exposed to financial risk.