Financial leverage reflects the amount of debt used in the capital structure of the firm
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.
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This is a graded discussion: 3 points possible
due Feb 4
Week 2 – Discussion Forum 21616 unread replies.
1616 replies.
Your initial discussion thread is due on Day 3 (Thursday) and you have until Day 7 (Monday) to respond to your classmates.
Your grade will reflect both the quality of your initial post and the depth of your responses. Refer to the Discussion Forum Grading Rubric under the Settings icon above for guidance on how your discussion will be evaluated.
Financial Leverage [WLOs: 2, 3] [CLOs: 1, 2, 3, 4] TwitterPrior to beginning work on this discussion, read Chapter 5: Operating and Financial Leverage in your textbook.
As you explored in your textbook, financial leverage refers to the amount of debt used in the capital structure of a business. The degree of financial leverage measures the effect of a change in the earnings per share (EPS) of the company that occurs because of a percent change in the earnings before interest and taxes (EBIT).
List some of the benefits and limitations of financial leverage when it comes to profitability. Then, explain the factors a company should consider when deciding which type of leverage plan (i.e., leveraged or conservative) it should follow.
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.
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Reply to Week 2 – Discussion Forum 2
COLLAPSE SUBDISCUSSION
Tonya Hatcher
Tonya Hatcher
“Financial leverage reflects the amount of debt used in the capital structure of the firm” (Block et al., 2019, p. 133). Financial leverage is simply the way an operation is financed. When a company is looking to launch or to grow, that business needs the finances to make that happen. The choices are simple, either allow others to invest in your company by selling shares of stock, or borrow the money. The higher a company’s financial leverage, the higher the debt and the greater the risk. In terms of profitability, financial leverage can have benefits, as well as limitations. But first, it’s important to really understand what financial leverage is and how it works. Think of it like this; you have an opportunity to invest in a “for sure” idea which promises to pay back what money you put in, plus another 50% in one month’s time. You feel that the $1,000 you currently have is not enough, so you borrow $4,000 from the bank, agreeing to pay $120 per month in interest. You invest all $5,000 in this “for sure” idea. A month later, you see $7,500 deposited into your pocket. Sure, the $1,000 would have profited $500, which is still a profit. However, because you took a bit of a risk and borrowed money, you were able to pay off the loan with interest ($4,120) in one month and pocket a total of $3,380. Now, had this not been a “for sure” investment, you may have leaned a bit more toward the conservative leverage plan of simply investing only your $1,000. If things went bad, you would still be out $1,000, but at least you would not be out that amount plus owe another $4,000 plus interest. Financial leverage would be best used by a company who is looking to purchase some type of asset which they expect will generate enough income to not only make the loan payments, but allow the company to see profits. If the asset does indeed generate enough income for that, then the risk was well worth it. However, if things go badly, the company can be left with a huge debt and no way to pay it. This is not the only disadvantage of using financial leverage in business. When a company borrows too much, it can make it hard to receive any additional funding should the need arise. The risk for the lender could be too great, causing higher interest rates and possible restrictions being placed on the loan by the lender. There are a few things a company must consider once the decision has been made to go ahead with an operation (Paniello, n.d). Should the funding be leveraged or conservative in nature? First, a company must think of its long-term goals. Will borrowing that $100,000 help you to achieve your long-term goals or will it hinder your ability to reach them? No matter how much money a company borrows, the fact remains that every dollar spent on interest is a dollar that is taken away from the company’s profits. How difficult will it be to acquire the financing needed to purchase the needed items? If a company has an opportunity to choose a low interest or specialty loan, the total cost of borrowing and financing the operation could be relatively low. Another item to consider is how much ownership do you really want to sell? Selling stock is always an option which can lead to less need to borrow money. However, the more investors a company has, the less profit you gain. The process to find the investors is also a time consuming one and not the easiest task to accomplish. The more you own of the operation, the more profits go into your pocket. The same is true of the losses if things go wrong. Finally, a company must really think about its ability to repay the loan, because the future cash flow could be inhibited as you pay the principal and interest payments on the loan. This can keep a company from growing in profitability over time. The decision of how to finance a business venture is a tough one, and there is risk no matter which way is chosen. The main question is how much of a risk should be taken by the company? Time and thought must go into this difficult decision.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.)Paniello, A. (n.d.). 7 Factors to Consider when Choosing Between Debt and Equity Financing for Your Young Business. Strategic Capital. https://capitalwithstrategy.com/factors-to-consider-when-choosing-between-debt-and-equity-financing/ (Links to an external site.)
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