Submitted by: Submitted by puddingpop
Views: 337
Words: 3377
Pages: 14
Category: Other Topics
Date Submitted: 05/08/2011 09:16 PM
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...