Week 2 Discussion 1&2 Responses
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BUS592Week2Discussion2ClassmateResponse.docxWeek 2 - Discussion Forum 2
Guided Response: Review the posts from your classmates and respond to at least two. How did their list of limitations differ from yours? What does their analysis tell you about the role of financial leverage in making financial decisions? Each response should have a minimum of 100 words.
On this Document there two classmates with discussion that needs to be response. Lisa James and Kyle Jablonski
MondayApr 13 at 8:10pm
According to Block, Hirt, and Danielson (2019) “financial leverage reflects the amount of debt used in the capital structure of the firm” (pg. 133). Financial leverage can be risky so it is important to understand the benefits and limitations of it.
One of the largest benefits is that it can lead to a larger return on capital for the investor. This is done by increasing the debt-to-income ratio. Taking on more debt can be seen as risky, especially if the economy takes a dive and sales decrease, but in a stable or growing market, the added risk can be very profitable (Woodruff, 2020).
However, taking on additional debt can be a limitation, especially if economic climates change. Sales and profits may decrease, but overhead expenses will stay the same, or even in some extreme circumstances, increase. Taking on additional debt can potentially lead to a default in any loan payment because of an inability to pay (Woodruff, 2020). Additionally, common stockholders could drive down the price based on concern (Block, Hirt, & Danielson, 2020).
It is important for a company to understand not only the current economic climate they are in but also any economic projections. This will help them to determine if the risk of additional debt that will be experienced from a leveraged plan will be worth it. If the answer is no, or even uncertain, the company may want to go with the security of the conservative plan. Additionally, it is important for a company to understand the amount of outstanding debt they have before taking on any new debt.
Resources
Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/
Woodruff, J. (2020, March 23). The Advantages & Disadvantages of Financial Leverage. Retrieved from https://bizfluent.com/info-10071658-advantages-disadvantages-financial-leverage.html
YesterdayApr 14 at 10:52pm
One of the benefits when it comes to a company utilizing financial leverage is additional funds being brought in to help manage growth. According to Block, Hirt, and Danielson (2019), “Highly leveraged firms, such as Ford Motor Company or American Airlines, are likely to enjoy a substantial increase in income as volume expands” (p. 131). With these borrowed funds and more assets being available, tax benefits also play a [positive role when a company is utilizing financial leverage. According to Bragg (2019), “Favorable tax treatment. In many tax jurisdictions, interest expense is tax-deductible, which reduces its net cost to the borrower” (para 3). This leverage allows for additional assets that are not generated from sales to help with a company's growth by allowing them to utilize resources that would not be available without financial leverage. Much like when someone borrows money in the form of a mortgage, one leverages their assets in order to purchase a home they would not have been able to purchase otherwise. With leverage comes potential downside and risk.
Some of the limitations that are associated with leverage is a company over-leveraging their own assets. “When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that debt. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales” (para. 8-9). Much like when someone takes out a mortgage to buy a house, someone could overextend their assets or what they are bringing in as revenue and may not be able to make up the debt. If an individual over leverages the assets they only need to answer to themselves, but when a company over leverages themselves, they have shareholders to report to. According to Block, Hirt, and Danielson (2019), “Concerned common stockholders may drive down the price of the stock—forcing us away from the objective of maximizing the firm’s overall value in the market” (p. 131). Driving down the price of the stock would negatively affect the companies' all already existing assets. This would be potentially high risk and comparable position. This could lead to a company going out of business or filing for bankruptcy.
It is important to take into consideration as a company why the risk of taking on debt and how long is the company going to be extending themselves. According to Block, Hirt, and Danielson (2019), “Those who are risk-averse (prefer less risk to more risk) should anticipate a particularly high return before contracting for heavy fixed costs. Others, less averse to risk, may be willing to leverage under more normal conditions. The important idea, which is stressed throughout the text, is to match an acceptable return with the desired level of risk” (p. 130). A useful way a company can utilize financial leverage is during the purchase of another company. For example, if the company is showing a constant positive cash flow of 1m dollars and the purchasing company is going to borrow 1m dollars for the purchase of this company, this would be a conservative way of utilizing leverage. If a company is going to take on debt to run a Super Bowl commercial, it is hard to determine what the return would be and how long the company would be in debt in order to run this advertisement. This would be a much riskier way of using leverage because the time frame is unknown and acquiring the same or similar results may be able to be accomplished without having to leverage the company’s assets.
References:
Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/ (Links to an external site.)
Balasubramaniam, K. (2020). Operating Leverage and Financial Leverage. Retrieved from https://www.investopedia.com/ask/answers/06/highleverage.asp (Links to an external site.)
Bragg, S. (2019). Financial leverage. Retrieved from https://www.accountingtools.com/articles/2017/5/14/financial-leverage (Links to an external site.)
