BUSI 320 Week 2 Discussion Board Forum 1 Example

Discussion Board Forum 1: Operating and Financial Leverage in a Growing Business

BUSI 320 Finance Principles, Discussion Board Forum 1 (Thread and Replies)

Thread by [Student Name]

The bakery figures and the classmates are composites; the textbook, research and Scripture cited are real.

Thread

Financial leverage helps a growing business only when sales are steady enough to cover its fixed costs and interest; when sales fall, the same fixed charges multiply the damage. Block et al. (2017) explain that operating leverage comes from fixed operating costs and financial leverage from fixed financing costs, and that combining them multiplies the effect of a sales change on earnings per share.

A composite bakery shows how this works. It sells $800,000 a year, with variable costs of $480,000, fixed operating costs of $200,000 and therefore earnings before interest and taxes of $120,000. It is considering a $400,000 loan at 8 percent to open a second location, adding $32,000 of interest. Its degree of operating leverage is contribution margin divided by EBIT, $320,000 divided by $120,000, or about 2.7. Its degree of financial leverage after the loan is EBIT divided by earnings before taxes, $120,000 divided by $88,000, or about 1.4. Combined leverage is about 3.6, so a 10 percent drop in sales would cut earnings per share by roughly 36 percent. The loan does not change how many loaves the bakery sells; it changes how much a bad month hurts.

Real financial officers seem to understand this. Graham and Harvey (2001) asked finance chiefs at hundreds of companies what governed their borrowing, and the top answers had little to do with tax shields: executives wanted to keep spare borrowing capacity and to protect their credit ratings. They borrowed with an eye on what would happen in a downturn, not only on the tax savings debt provides.

Scripture adds a caution. Proverbs observes that the borrower becomes servant to the lender (English Standard Version Bible, 2001/2016, Proverbs 22:7). Borrowing is not forbidden, but it limits freedom, and a business owner should borrow only when the plan can survive a slow year. For the bakery, that means testing whether the second location's sales could fall 10 percent without endangering the loan payments.

Reply to Jordan

Jordan, your percent-of-sales forecast for the hardware store was clear, and Block et al. (2017) present exactly that method for estimating how much new financing growth requires. I would add one check. The method assumes assets grow in proportion to sales, but some assets, such as a building, grow in steps rather than smoothly. If the store is already near capacity, a 20 percent sales increase might require a new warehouse, not 20 percent more of everything. Would it help to separate the store's fixed assets from its inventory and receivables when you forecast?

Reply to Hannah

Hannah, you argued that debt is always cheaper than equity because interest is tax deductible. The tax advantage is real, but Graham and Harvey (2001) found that executives worried most about losing flexibility and hurting their credit ratings as debt rose. Those are costs too, even if they do not appear on the income statement. A firm with heavy debt may have to pass up a good investment during a downturn because lenders will not extend more credit. Do you think the cost of that lost flexibility could outweigh the tax savings for a small business?

References

Block, S. B., Hirt, G. A., & Danielsen, B. R. (2017). Foundations of financial management (16th ed.). McGraw-Hill Education.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7