Fin. Planning Study Guide

Chapter 7 – Debt

Leverage and Risk

-The higher the debt, the higher the household’s risk.

-People who have too much debt are said to be over leveraged.

Operating Risk – arises from uncertainties in connection with household activities.

Financial Risk – comes from the amount of debt outstanding relative to your assets.

Operating Leverage – the degree to which you have fixed costs in your budget that come from household operating functions.

- The greater percentage of your nondiscretionary costs – high fixed costs cannot easily and quickly be cut back – the greater your operating leverage.

- When you have high FC, a modest increase or decrease in your income can have a material impact on your free cash flow

Financial Leverage – arises from the amount of debt outstanding and its contributions to household fixed costs.

- The greater the amount of your interest expense and debt repayment commitments, the greater you financial leverage

- When you have high fixed financial costs, a change in your income can have substantial effects on your free cash flow

- Can increase potential rewards for the household, it can allow us to purchase and enjoy benefits of something earlier

- Undertaking additional debt has two side effects: increases risk and increases potential returns

Determining Simple Interest Rates

Interest rate – is the cost for the money borrowed (need this to make a proper decision)

-To calculate the real interest rate, you need to know the time period for the loan and the actual amount of money that is made available

Example:

–A $5,000 loan.

–A $600 yearly cost to borrow.

–A one-year investment.

If the interest is paid at the end of the period, then:

-You obtain the use of the money for the entire period

If the interest is paid at the beginning of the period, then:

-When interest is deducted at the beginning of the period, the amount paid in interest is the same, but the cash made available is...