Problem 2. What is operating leverage? How, if at all, is it similar to financia

Question

Problem 2. What is operating leverage? How, if at all, is it similar to financial leverage? If a firm has high operating leverage, would you expect it to have high or low financial leverage? Explain your reasoning.

Problem 6. Why might it make sense for a mature, slow-growth company to have a high debt ratio?

Problem 10. FARO Technologies, whose products include portable 3D measurement equipment, has 400 million shares outstanding trading at $5 a share. The company announces its intention to raise $200 million by selling new shares.

a. What do market signalling studies suggest will happen to FARO’s stock price on the announcement date? Why?

b. How large a gain or loss in aggregate dollar terms do market signalling studies suggest existing FARO shareholders will experience on the announcement date?

c. What percentage of the amount of money FARO intends to raise is this expected gain or loss?

d. What percentage of the value of FARO’s existing equity prior to the announcement is this expected gain or loss?

e. At what price should FARO expect its existing shares to sell for immediately after the announcement?

Explanation / Answer

Problem 2: Operating leverage measures the extent to which a company requires to borrow for fixed and variable costs of production. Fixed costs do not change with the increase or decrease in company's production whereas variable costs are directly proportional to the company's production which mean they change according to the level of production

Financial leverage refers to the amount of long term debt which alters the firm's capital structure. They affect the shareholder wealth in terms of reduced earnings due to higher interest outgo.

Operating leverage affects the EBIT (Earnings before interest and tax) to changes in sales whereas financial leverage affects the EPS (Earnings per share) as explained in the previous point.

Companies which high operating leverage are those which have higher ratios of fixed costs to variable costs. This does not affect the financial leverage. A company may borrow short term to meet its working capital which will increase operating leverage and this will have no effect on the capital structure of the firm which refers to the amount of debt and to the amount financial leverage.

Question 6: A slow growth company will have to take on additional debt in the initial years of operation to invest in capital assets which will generate growth over the long term. Hence during the initial years, a low growth company will have higher debt ratio and this will have to reduce slowly over the long term as the company picks and repays its debt gradually.

Note: We have answered 2 full seperate questions. Kindly repost the next as a seperate question for experts to answer

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