Question

Session 5 Issues in Finance Please read the following and respond with a minimum 100 word commentary at title link above. Your discussion should reflect original thoughts and opinions. Chapter 12 discusses financial and operating leverage. What is leverage? In your opinion, under what scenarios can it be viewed as a good thing? Under what scenarios can it be viewed as a bad thing?

Answer 1

Leverage:

• Leverage is defined as use of borrowed funds aimed at generating a return on equity for investors.
• Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital.
• Leverage is an investment strategy of using borrowed money specifically, the use of various financial instruments or borrowed capital to increase the potential return of an investment.
• Leverage can also refer to the amount of debt a firm uses to finance assets.
• When one refers to a company, property or investment as "highly leveraged," it means that item has more debt than equity.
• Various types of leverages are Operating Leverage, Financial Leverage, Combined Leverage.
• The biggest advantage of leverage is that it helps in increasing the liquidity available to the company.
• Another advantage of leverage is that companies which do not want to dilute their ownership this route of financing is good because in case of debt financing or loan company has to repay the principal amount on maturity along with periodical interest and there is no risk of giving equity to anybody resulting in complete control of the company by the owners of the company.

Disadvantages of leverage are:

• Since leverage means paying regular interest payment without any delay it puts an obligation on the company to pay interest no matter what the financial position of the company is and in worst case scenario it can even lead to the bankruptcy of the company.
• The biggest disadvantage of leverage is that there is a risk that company uses too much leverage which in turn can lead to problems for the company as beyond an optimum level of leverage there will no benefit of taking leverage.