© 2000 John Petroff
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© 2000 John Petroff |
Companies borrow for many different reasons. Let us consider first the following list of justification: working capital expansion, equipment replacement, advertising campaign, retirement of more costly debt. All these reasons do not constitute seriously dangerous financial leverage, and can be considered benign uses of debt because in each case there is a clear purpose of improving sales or reducing costs. What is not a benign use of financial leverage, is when a company uses debt to take on additional risk. For instance, when the proceeds from debt are used to acquire additional resources (i.e. fixed assets for most part) which will be used to seek additional sales. Such a strategy is at the core of capital budgeting, and is part of the necessary growth process of all firms.
There may be a few cases of down-sizing and just-in-time configuration where resources increase variable costs relative to fixed costs by reducing fixed plant. But, most corporate growth comes from moving along the learning curve (described in Chapter 9), automating and using more (rather than less) fixed plant. This means that debt is used to increase fixed assets, fixed costs and therefore operating leverage. This establishes that there is natural connection between financial leverage and operating leverage. This combination needs to be investigated.
See review question Q-11D1.1 .
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