Operating leverage is important because of its impact on the risk of the investment. However, a firm’s choice of operating leverage is limited by the number of possible different methods of producing a product or service. In some cases, a firm has little or no choice because there is a single (or most efficient) method of production.

There are two important things to remember about operating leverage. First, operating leverage is generally unique for each investment rather than identical for all of the firm’s investments. Second, operating leverage affects the total risk of the capital budgeting project, both diversifiable and nondiversifiable risk. Therefore, it also affects both the project’s beta and its cost of capital.
Financial Leverage

Operating risk depends principally on the nature of the investment, and to a lesser extent on the firm’s choice of operating leverage. In contrast, financial risk depends mostly on financial leverage. When a firm has some debt financing, that portion of its financing costs is fixed rather than variable. Although we would expect a larger return to shareholders than to debtholders, shareholder return can vary from one period to the next without affecting the operation of the firm. However, failure to make required debt payments can result in bankruptcy. We could say, then, that financial leverage substitutes fixed payments to debtholders for variable payments to shareholders.

Graphically, financial leverage looks a lot like operating leverage. The realized return to the shareholders (owners) in an all-equity-financed firm is the same as the realized return to the firm. The realized return to the shareholders in a leveraged firm is the realized return after the fixed payment to the debtholders has been taken out. The shareholders are the residual owners.

Figure 8-3 illustrates the shareholders’ realized return as a function of the firm’s realized return with and without leverage. The leverage alternative assumes 50%...