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Chapter 2: Q5-2DQ (page 143)

What factors would cause a difference in the use of financial leverage for a utility company and an automobile company?

Short Answer

Expert verified

A utility company would have more demand. Hence, the future profits can be calculated with more certainity. It will increase the financial leverage of the company at lower risk of incurring the cost of financial distress. On the other hand, more risk is involved in an automobile company. Its profit forecast is volatile. Hence, the automobile company would choose the lower financial leverage.

Step by step solution

01

Step-by-Step Solution:Step 1: Financial leverage

Financial leverage means the borrowing which is used to purchase the asset with the expectation that the income from the new asset will exceed the cost of borrowing.

02

factors affecting the financial leverage

Financial leverage is affected by the company鈥檚 profitability, growth opportunities, tangibility of assets etc. If the company is operating in the business with a high demand, the company would increase the financial leverage of the company and vice-versa. Hence, the utility company (providing service for basic need) have more demand than the automobile company (for luxury items). Hence, the utility company should increase the financial leverage and the automobile company should lower the financial leverage.

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