- Capital to stand in the market in the long-run inspite of rising input
cost and lowering sales price. - Switching over to new products or old product with new design or
with new name or new packing etc. in a shorter span of time. - The new cost-effective production ideas.
- In case of foreign trade activities the earnings may vary due to
fluctuations in exchange rates. - The effect of operating leverage, i.e. fall in demand for product
without fall in its high fixed cost.
1.9 The fixed costs normally do not fluctuate. Therefore a small fall in sales may lead
to a larger fall in RoE. In other words, business risk will be higher, if the fixed
costs are high. The higher the degree of operating leverages, the higher the
business risk.
1.10 Technological innovations are utilized to reduce larger investments in fixed
assets. Failure to make technological adaptations can result in collapse and
closure of the company, as in the case of Yezdi in Mysore.
1.11 Capital budgeting decision is based upon the initial investment and its operational
or utility cost, and not just on the initial investment alone. Therefore, some of the
higher fixed costs may lead to lower variable costs i.e. the lower operational or
utility costs.
1.12 Each project will have different degrees of operating leverage. Different
methodologies will have different degrees of operating leverage even for the same
result in a given project. Therefore, the concept of operating leverage is useful for
project choice or for selection of an appropriate method out of many alternative
methods.
- Financial Leverage
2.1 A firm may finance a new plant or expand an existing plant through debt (also
called as financial leverage) or through equity.
2.2 If financed through debt, the business risk would concentrate on the existing
common stock holders because the debt holders would get fixed interest
payments; the debt holder therefore do not bear the business risk. In other words,
using financial leverage in the form of debt finance shall place the business risk
totally on the common stockholder.
2.3 In case of financing through both the sources, namely debt and equity, the capital
budgeting decision shall focus on Appropriate Ratio. The higher the debt
(financial leverage) and lower the equity, the higher the business risk on the old
stock investors plus on the new stock investors.