Leverage, Risk, and Self-Financing Strategies
Item 10: Leverage and Risk
Break-Even Point
The break-even point helps us determine the sales level needed to cover all costs. It also reveals the potential loss of sales or profits when considering alternative balance sheet values.
There are two types of costs:
- Fixed costs: These are independent of production volume.
- Variable costs: These vary directly with the volume of production.
The break-even point in units (Q) is calculated as:
Q = Fixed Costs
Price – Variable Costs
Operating Leverage
Operating leverage refers to the situation where a small change in sales causes a significant change in profits.
Degree of Operating Leverage (DOL) = Q * (P-Cv)
Q * (P-Cv) – Fixed Costs
Financial Leverage
Financial leverage affects profit after deducting interest on debts and taxes; that is, the shareholder’s benefit.
Degree of Financial Leverage (DFL) = Q * (P-Cv) – Fixed Costs
Q * (P-Cv) – Fixed Costs – Interest
Total Leverage
Total leverage is the relationship between a variation in sales and the variation in shareholder benefit.
Degree of Total Leverage (DTL) = Q * (P-Cv)
Q * (P-Cv) – Fixed Costs – Interest
Item 11: Self-Financing or Internal Financing
Introduction
Self-financing refers to resources that do not need to be repaid. Financing comprises its own self-financing and capital contributions.
Self-financing is the retention of profits generated by the company.
- Self-financing by maintenance (depreciation)
- Self-financing by enrichment (reserves)
Depreciation
Wear and tear is a real asset depreciation, and this depreciation is charged as a cost, which is depreciation.
Depreciation types:
- Physical depreciation: The mere passage of time makes an asset lose value.
- Obsolescence: An asset becomes outdated or inappropriate for current circumstances.
- Depreciation from exhaustion or expiration: This occurs when companies deplete a resource used under a particular concession.
Expansionary Effect of Depreciation (Lohmann-Ruchti Effect)
Under certain assumptions, depreciation not only maintains the productive capacity of the company but also contributes to its expansion.
These are the three basic assumptions:
- The company is in a phase of expansion.
- The production team is divisible.
- There is no obsolescence affecting the duration, acquisition cost, or production capacity of the equipment.
Self-Financing and Financial Decisions
Self-Financing and Investment Decisions
- Due to the opportunity cost of self-financing
- Due to risk
- Due to the availability of funds
Self-Financing and Funding Decisions
:
when a company has a policy of constant debt, increased cash flow, allowing an increase in indebtedness without worsening our solvencia.a this process is called “multiplier effect of self-financing”
if we have:
K = capital D = A = SELF-FINANCING resources other debts or liabilities totaling P = P = K + A + D
d = D leverage that assumes that the company wants to maintain constant
P
P = 1 where:m = 1 which is the multiplier of self-financing
1-d 1-d
advantages and disadvantages of self-financing
advantages: it allows greater degree of autonomy that a capital
is a form of financing that should not be remunerated
-for many companies is almost the only solution to obtain financing
-can undertake investment projects that otherwise would not be made
drawbacks: SELF-FINANCING-excess can make you lose important investment opportunities
-can cause a decrease in profitability
-decreases the stock returns
-produces imbalances in the distribution of investment
-may encourage tax evasion