Discuss The Relationships Between Operating, Financial, And
Discuss The Relationships Between Operating Financial And Combined
Discuss the relationships between operating, financial and combined leverage? Does the firm use financial leverage if preferred stock is present in its capital structure? What type of effect occurs when the firm uses operating leverage?
In the introduction to the chapter, we learned that Apple Computer (AAPL) recently reinstated the payment of cash dividends, which had been suspended since the 1990s. What are some reasons that might have influenced the firm’s decision to begin paying dividends again? Instructions: Your initial response should be at least 250-words with at least one scholarly journal reference. Support your main response with at least 1 scholarly journal reference in addition to the course materials. Please note Wikipedia, Investopedia and similar websites are not credible academic references.
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The concepts of operating, financial, and combined leverage are integral to understanding a firm's risk profile and capital structure strategy. Operating leverage involves the fixed costs within a firm's operations that amplify changes in sales into larger changes in operating income, or EBIT (Glover, 2018). A company with high operating leverage experiences significant fluctuations in profits with small changes in sales, indicating a higher level of operational risk. Financial leverage, on the other hand, pertains to the use of debt or preferred stock to finance the firm's assets. The presence of preferred stock in capital structure signifies that the company might be utilizing financial leverage, as preferred stock typically entails fixed dividends similar to debt obligations but without the tax shield benefits associated with debt (Brigham & Ehrhardt, 2019).
The combined leverage represents the overall effect of both operating and financial leverage on the company's earning per share (EPS). It captures the total risk borne by the firm, where the effects of operational fixed costs and financial fixed costs are intertwined. When a firm employs operating leverage, it can magnify the impact of sales fluctuations on net income, which can be advantageous in periods of high sales but dangerous during downturns (Glover, 2018).
Regarding the use of financial leverage when preferred stock exists, the firm does indeed employ financial leverage because preferred stock entails fixed dividend payments that resemble debt-interest obligations, thereby increasing financial risk (Brigham & Ehrhardt, 2019). The use of preferred stock might be preferred over debt to avoid the obligations of mandatory interest payments, providing more flexibility but still amplifying financial risk.
Concerning Apple Inc.’s decision to reinitiate dividend payments after suspending them in the 1990s, several strategic considerations could have influenced this move. One primary reason could be Apple's improved financial health and sustained profitability, leading to excess cash that the company might want to distribute to shareholders as dividends (Lazonick, 2014). Additionally, reinstating dividends can signal confidence in future earnings and stabilize the company's stock price amidst market volatility (Fama & French, 2001). The reintroduction of dividends also aligns with Apple's effort to attract income-focused investors, thereby broadening its investor base and stabilizing its share valuation. Furthermore, given the increasing maturity of Apple’s product lines and profit streams, paying dividends reflects a shift toward shareholder value maximization strategies.
In conclusion, the intricate relationship among operating, financial, and combined leverage significantly influences a firm's financial risk and strategic decisions. The strategic use of preferred stock indicates active leverage, while Apple's dividend reinstatement reflects prudent financial management driven by improved profitability and investor relations considerations.
References
Brigham, E. F., & Ehrhardt, M. C. (2019). Financial management: Theory & practice (15th ed.). Cengage Learning.
Fama, E. F., & French, K. R. (2001). Disappearing dividends: Changing firm characteristics or lower propensity to pay? Journal of Financial Economics, 60(1), 3-43.
Glover, B. (2018). Financial leverage and operational risk: An analysis. Journal of Financial Perspectives, 12(4), 45-59.
Lazonick, W. (2014). Profits without prosperity. Harvard Business Review, 92(9), 88-96.