Question 1
Operational leverage is when the company utilities fixed cost assets as a source of cash for its operation while financial leverage is where the company uses sources of funds that have fixed interest charges. The degree of operating leverage is preferable as the company can regulate leverage using its fixed assets. For example, a capital-intensive company can have high leverage since it uses a lot of machinery which increase its fixed asset while a company with a low leveraged company is one that uses less fixed costs in its operations (Hall, 1989). Therefore, operational leverage can be regulated internally by the company’s policies as opposed to financial leverage which brings about a financial risk that is affected by external forces.
The degree of applying operational leverage depends on the maximization of profit by keeping sales at a significant rate higher than fixed costs (Modigliani et al., 1958). Some leverage degree is used to sustain growth in a company during periods of economic downturn. It does this through the replacement of expensive fixed costs with cheaper variable costs. Amazon carries out most of its operation through the internet, hence does not have high fixed costs such as facilities. By maintaining this low degree of operational leverage, the company managed to sustain growth with little profit.
Delegate your assignment to our experts and they will do the rest.
Question 2
Ignoring any tax consequence the annual payments will be 1000000/20 years = $50,000 annually. Any interest rate above zero per cent will lead to an increase in the cumulative amount to be higher than the initial lump sum (Frederick et al., 2002). However, other factors such as inflation might affect the value of the annualized payments. For example, an increase in inflation rate will cause the amount of the annualized payment to be lesser than the value of the initial lump sum. Investment of the lump sum in the stock market will yield returns that are determined by the current cost of capital and interest rates in the market (Baum et al., 2013). Therefore, a company can decide on the percentage rate that may result in the expected returns, or that suits its investment strategy.
Question 3
Investment Decisions
A manager can reduce risk by carrying out a scenario-based analysis of project cash flow projections. For example, he can do a best- and worst-case scenario analysis of the projected cash flows to identify the best possible cash flows (Maravas et al., 2012). The manager can also carry out a SWOT analysis of the estimated cash flows to identify the strengths, weaknesses, opportunities and threats that may increase or decrease risk. Economic value Added can be used to reduce uncertainty by determining the amount of change in the shareholders’ wealth as a result of Capex decisions made (Mun, 2002). Economic Value Added uses the weighted cost of capital which minimizes uncertainty since it is free from bias. Therefore, analysis of project cash flows is paramount in risk management in any investment.
References
Baum, A., Baum, C. M., Nunnington, N., & Mackmin, D. (2013). The income approach to property valuation . Estates Gazette.
Frederick, S., Loewenstein, G., & O'donoghue, T. (2002). Time discounting and time preference: A critical review. Journal of economic literature , 40 (2), 351-401.
Hall, B. H. (1989). The impact of corporate restructuring on industrial research and development (No. w3216). National Bureau of Economic Research.
Maravas, A., & Pantouvakis, J. P. (2012). Project cash flow analysis in the presence of uncertainty in activity duration and cost. International journal of project management , 30 (3), 374-384.
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review , 48 (3), 261-297.
Mun, J. (2002). Real options analysis: Tools and techniques for valuing strategic investments and decisions (Vol. 137). John Wiley & Sons.
