Question

In your own words, describe how VAR could be utilized to estimate the impact of adding new projects to a firm. Do you feel there is anything management can do to mitigate the operating leverage of the firm to control the VAR of future investments? For example, how are financial and operating leverage related? 300 words

Answer 1

VAR stands for value at risk. VAR is measure which tell us with a certain level of probability as to how much money we can lose over a certain period of time. VAR can be useful in assessing the project cash flow and degerming with different level of probability how much cash flow can be lost over a certain period of time due to certain changes. Operating leverage shows the how much is the fixed cost the company is using whereas the financial leverage measures the effect of interest expense. With the operating leverage the main issue is that even if the company is not producing or generating sales the fixed cost would continue to occur and that can significantly affect the operating margin. The management can take certain steps to reduce the direct fixed cost associated with the project. Steps like automating the direct labor function will help in reducing the fixed cost associated with the project. By doing this in the short-term there would be capital outflow but in the long-term the fixed cost can be reduced and the variable cost are also reduced sometimes. If variable costs are reduced then the contribution margin will increase which will help in reducing the volatility in the cash flows. VAR is majorly used in trading and portfolio management as to measure how much minimum losses can occur over a certain period of time with certain level of confidence, in project cash flow it can help in understanding the volatility level of cash flow at different level of probability.