Review the posts from your classmates and respond to at least three. How did their list of limitations differ from yours?

Assignment Question

Review the posts from your classmates and respond to at least three. 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.

Delaney’s Post- Benefits and limitations of financial leverage A major consideration a business has to make in its founding, maintenance, and potential expansions, is how it will fund all of the costs that go into each step. One way to do so is for the business to use financial leverage. The main benefit of financial leverage is the potential to earn a lot more money for the company when a leveraged plan is used as compared to a conservative plan. This is because actually borrowing the money creates fixed financial costs, in the form of the interest rate on the borrowed money, whereas the financial costs on stock shares could be more variable. Looking at EPS and EBIT as mentioned in the prompt, there is a point at which the leveraged plan and the conservative plan intersect, after which the leveraged plan makes earnings per share at a much steeper rate (Block et al., 2022). As stated by Labes, other benefits that could come from using financial leverage are possible tax deductions, higher ROIs, and a lower cost of capital versus equity (2023). Despite the potential benefits, there are also limitations to be aware of. One consideration is an increased use of debt to finance a company will begin to look risky to potential investors or lenders. If that happens, those people could try to protect themselves by doing things such as increasing interest rates or placing restrictions on the company. There could also be affects from stockholders that are financing the other portion of the company, in which they could become nervous about the finances of the company and actually end up driving down the price of the company’s stock (Block et al., 2022). These concerns are also considered by Labes. To summarize, a high use of leveraged finance increases risk of bankruptcy, decreased valuation of the company, and general financial distress if there is a high amount a company must take from its earnings to pay back its debts (2023). Benefits and limitations of using financial leverage should be carefully considered as a company decided how best to finance its operations. Factors a company should consider when deciding on a leverage plan Using a “leveraged” plan for financing a company means that the company borrows money, accruing debt, to meet total financing needs. The smaller amount of money still needed to meet the needs of the company can be earned by selling shares of stocks. In contrast, a conservative plan to finance will involve accepting a more minimal amount of debt, primarily using the sale of stocks to finance the company (Block et al., 2022). The risk of using financial leverage is that when it works, it really works, but when it doesn’t it can be detrimental. That is because the earnings potential gained is also the potential for loss. The company must be prepared to face those risks of loss. Another particular factor the company should consider when thinking about using a leveraged plan are current interest rates on the loans and the potential for interest rates to increase (Hemeon, 2019). The various benefits, limitations, and other factors are all important. The way that a company chooses to finance its operations will have a great affect on the potential profits that can be made.

References Block, S. B., Hirt, G. A., & Danielson, B. R. (2022). Foundations of financial management (18th ed.). McGraw-Hill Education. Hemeon, J. (2019, November 7). To leverage, or not?. Investment Executive. https://www.investmentexecutive.com/newspaper_/building-your-business-newspaper/to-leverage-or-not/Links to an external site. Labes, O. (2023, October 30). Operating leverage and financial leverage – key to business profitability or catalyst to financial distress. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/fpa/operating-financial-leverage/Links to an external site.

Samson’s Post- Benefits of financial leverage: How a business will pay for all the costs that come with starting up, running, and possibly growing is one of the most important things it needs to think about. One way for the company to do this is to borrow money. One of the best things about financial leverage is that it can help a company make a lot more money than if it used a safe plan. This is because borrowing money has set costs, like the interest rate on the loan, while the costs of buying stock shares could change more often. When you look at EPS and EBIT like the prompt suggested, the conservative plan and the leveraged plan meet at a certain point. From there, the leveraged plan makes much more earnings per share (Block et al., 2022). Labels says that extra money borrowed could also help with tax breaks, better returns on investment, and a lower cost of capital compared to equity (2023). Limitations of financial leverage: Even though there might be perks, there are also some things that you should know. One thing to think about is that if a business uses a lot of debt to fund itself, possible investors or lenders will start to see it as risky. If that happens, those people might try to protect themselves by doing things like making the company follow certain rules or raising interest rates. Stockholders who are funding the other part of the business could also have an effect. They might worry about the business’s finances and drive down the price of its shares (Block et al., 2022). Labes also thinks about these worries. By way of summary, a company that uses a lot of leveraged finance is more likely to go bankrupt, have its value drop, and be in general financial trouble if it has to take a lot of its earnings to pay back its loans (2023). When a business decides how to best fund its operations, it should carefully think about the pros and cons of using financial debt. Factors in Choosing a Leverage Plan: When a business uses a “leveraged” plan to get money, it takes money and builds up debt to cover all of its funding needs. Selling shares of stocks is one way to get the small amount of money the company still needs. A safe plan to finance, on the other hand, will involve taking on less debt and mostly selling stocks to pay for the business (Block et al., 2022). Leveraging your money comes with the chance that it will only work when it really works, and it could hurt you when it doesn’t. That’s because the chance of making money is also the chance of losing money. The business needs to be ready to deal with those lost risks. When the company thinks about using a leveraged plan, it should also think about the interest rates on the loans and the chance that those rates will go up (Hemeon, 2019). All of the different pros, cons, and other factors are significant. The amount of money a business has to run its processes will have a big impact on how much money it can make.

Block, S. B., Hirt, G. A., & Danielson, B. R. (2022). Foundations of financial management (18th ed.). McGraw-Hill Education.

Kevin’s Post- A significant benefit to financial leverage is a higher earnings per share (EPS) for the stockholder. This is due to much of the operating income being financed, with a fixed-rate loan, instead of being funded by selling additional stock. By not selling the additional shares it enables higher EPS for the stockholder because less stock has been sold. When using Block’s example of Plan A (leveraged) and Plan B (conservative) in table 5-5, it is evident that a leveraged firm with higher earnings before interest and taxes (EBIT) will be significantly more profitable as earnings increase. Limitations of being financially leveraged are important to understand as well. Paul states that “excessive use of debt also has its own disadvantages. It may subsequently downgrade the firm’s credit rating, and possibility of financial distress increases, resulting in reduction in the value of the firm” (Paul 2023). Along with paying higher interest rates and negatively impacting the firm’s credit rating, the stockholder should understand that the more leveraged a firm is the higher the financial risk. I think the primary factors that should be considered when deciding how much financial leverage to use are the state of the economy, economic projections, and stockholder confidence. If the economy is in a bad state or beginning to recede it would be more prudent to use a more conservative approach (less leveraged). Also, as Block mentions, “concerned common stockholders may drive down the price of the stock” which could also be a reason to utilize a more conservative approach. Finding the balance is key.

References: Block, S. B., Hirt, G. A., & Danielson, B. R. (2022). Foundations of financial management (18th ed.). McGraw-Hill Education. Paul, P. (2023). Impact of Capital Structure on Firm Performance: Eviden. IUP Journal of Accounting Research & Audit Practices, 22(3), 5–13.