Which of the following events would decrease financial leverage? A) Issuing debt to purchase assets. B) Purchasing goods on account. C) Paying dividends. D) Issuing common stock to purchase assets. Your answer: B was incorrect. The correct answer was D) Issuing common stock to purchase assets. Acquiring assets by issuing stock decreases the degree of financial leverage since total assets are increased but total liabilities remain the same. **** What about other options? Does paying dividend affect anything?
paying dividends decreases assets and retained earnings (equity portion) issuing debt to purchase goods or purchasing goods on accounts increases the leverage.one increases long term debt the other short term
You take up no additional liability by issuing new common stocks… but for other kinds of financial sources like Preferred Stocks, you are obliged to pay preferred dividends… For Bond issues, you are obliged to pay coupon payments So D looks good to me… - Dinesh S
florinpop Wrote: ------------------------------------------------------- > issuing debt to purchase goods or purchasing goods > on accounts increases the leverage.one increases > long term debt the other short term In these two case both debt and equity would increase. Goods purchased would increase NI -->Increase Equity. This could increase or decrease the leverage depending on the existing leverage ratio. If the existing debt to equity is less than 1 then the leverage would increase else decrease. But D would definitely decrease the leverage. Is this understanding correct or did i over analyse?
buying a good does not increase NI so it does not increase equity either.
Issuing common stock would increases equity.
why would if the purchased good increases productivity??? like maybe a food processor in the restaurant…thats all i could think
Yeap you are going way to far with your thoughts Think just first phase what happens
Its a purchased “asset” hopefully that will be used in production
delhirocks Wrote: ------------------------------------------------------- > Its a purchased “asset” hopefully that will be > used in production Well Option A is purchasing an asset
Hang on folks! What does liability have to do with this? What is financial leverage? It is total assets divided by equity (straight from the DUPONT equation). So, i don’t know why the explanation to the answer talks about liability. Second, issuing common stock to purchase assets may or may not decrease financial leverage depending on what the ratio was before the issuing took place. Comments? Dreary
Dreary Wrote: ------------------------------------------------------- > Hang on folks! > What does liability have to do with this? What is > financial leverage? It is total assets divided by > equity (straight from the DUPONT equation). So, i > don’t know why the explanation to the answer talks > about liability. FYI, only DuPont uses A/E as a leverage ratio, only so they can force-fit it into their model. The rest of the universe uses D/E or D/A. > Second, issuing common stock to purchase assets > may or may not decrease financial leverage > depending on what the ratio was before the issuing > took place. Comments? > Dreary Issuing common stock will increase leverage only if E>A; i.e. D<0. Not really likely.
> FYI, only DuPont uses A/E as a leverage ratio, only so they can force-fit it into their model. > The rest of the universe uses D/E or D/A. Wonderful! So how should we take it on the exam? Ignore DuPont? Dreary
Either the exam will define leverage exactly, or it’ll be a directional question, and any of ratios increases when leverage does.
Definitely D. Think of Financial Leverage as the Debt to Equity ratio, since financial leverage chiefly measures financial risk (how much debt you are using as compared to equity). A is wrong because issuing debt would increase the D/E ratio thus increasing leverage B is wrong because you’re opening a payable by purchasing on account, thus increasing debt thus increasing leverage C is wrong because paying dividends reduces retained earnings, thus reducing equity. If the denominator in the D/E ratio is smaller, the D/E ratio is bigger thus increasing leverage D is right because issuing common stock increases equity, makes the denominator in the D/E ratio bigger and therefore makes the D/E ratio smaller, thus DECREASING financial leverage. I hope that’s not too confusing