Monday, 18 February 2013

Why firms use debt as leverage?


Using Debt as Leverage


Its all about financing decisions and to reduce the costs of equity and debts. A company uses leverage in two ways: financial and operating. 

Financial leverage is raising capital through debt rather than equity. While debt-holders are entitled to interest, the owners share the earnings of the company. Hence, when a company can earn a higher rate of return on its invested capital through its operations than the interest rate on its debt, it could increase the return for its investors by financing the growth of company operations through borrowed capital.

Operating leverage is the existence of fixed operating costs. Because these costs are fixed, the higher the percentage of operating leverage, the greater the effect changes in sales revenues have on operating income.
The focus on leverage in this section will be on financial leverage. The cost of financial leverage is interest costs, which must be paid regardless of sales. 

1 comment :

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