Leverages

This assignment is a diligent effort to understand and analyse

while interpreting operating , financial and combined
leverage of top 30 companies of Standard & Poor's 500
Index.
In physics leverage implies the use of lever to raise a heavy
object with small force. In politics , if people have leverage
their smallest word or action can accomplish a lot. (Brigham
& Ehrhardt, 2012)
In business terminology , a high degree of operating
leverage, other factors held constant , implies that a
relatively small change in sales results in a large change in
EBIT. (Brigham & Ehrhardt, 2012, p. 567)
Leverage Refers to the effects that fixed costs have on the
returns that shareholders earn; higher leverage generally
results in higher but more volatile returns (Gitman & Zutter,
2012, p. 508).

The amount of leverage employed by a firm directly affects

its risk, return, and share value. Generally, higher leverage
raises risk and return, and lower leverage reduces risk and
return . Operating leverage concerns the level of fixed
operating costs ; financial leverage focuses on fixed financial
costs ,particularly interest on debt and any preferred stock
dividends. The firm’s payments, the more debt a firm
employs relative to its equity , the greater its financial
leverage (Gitman & Zutter, 2012).
The S&P 500 or Standard & Poor's 500 Index is a market-
capitalization-weighted index of the 500 largest U.S. publicly
traded companies.
There are two kinds of charge on the cash flows of the
firm: fixed and variable. Furthermore, the fixed charge is also
of two types: one resulting from the cost structure and the
other from the financing structure. (Srivastava & Misra, 2018,
p. 440)

To use the fixed-charges sources of funds, such as debt

preference capital along with the owners equity in the capital
structure, is described as financial leverage or gearing and
trading on equity.

Capital Structure Modigliani and Miller [1958, 1963] started

modern corporate finance with the conclusion that the mix of
debt and equity, its capital structure had no effect on the
entity value. Soon the debate moved to the trade-off
between the value of the tax deductibility of interest
payments on debt versus bankruptcy costs (e.g., Baxter
[1967]). The most modern literature in this area (e.g., Leland
[1994] and Leland and Toft [1996]) has refined the topic to
describe the value of the levered firm as its value as
unlevered, plus the present value of two tax terms, one
without default risk and a second negative term reflecting
the present value of tax shield that is lost as more debt is
added to the capital structure mix due to the increased
probability of default, and finally the present value of
business disruption costs. Modigliani and Miller had
maintained the assumption that greater debt loads did not
affect the operating profits of the firm (its EBIT). When
relaxed, this assumption becomes important because
operating and financial flows are no longer treated as
independent. Optimal capital structure can result. But can
the trade-off between the value gained by the tax shield
provided by debt and the greater likelihood of incurring
business disruption costs explain cross-sectional regularities
in capital structure? This is a classic, unsolved question.
(Copeland, Weston, & Shastri, 2007, p. 888)

In most of the cases leverage has magnifying effects on EBIT

but it is tricky to use leverages . The key to using leverage
successfully is common sense, realistic assumptions, and a
clear-eyed understanding of the risks. (Firestone, 2012)
One example was Orion Pictures, a small studio created by
well-regarded, disgruntled United Artists executives in the
late 1970s. They raised money for a slate of films and,
remarkably, produced four Oscar winners for Best Picture
between 1978 and 1992: Amadeus, Platoon, Dances with
Wolves, and The Silence of the Lambs. Despite that critical
success, Orion was ultimately undone by the combination of
movie misses that far outnumbered the hits and debt that
ballooned to over $500M. Unable to meet its interest
payments, the company filed for bankruptcy in 1991. Orion
wasn’t the only one. Overzealous borrowing habits
contributed to the rise and fall of many other entertainment
companies during the 1980s and 1990s, such as New World
Pictures, Carolco, Cannon Group, De Laurentis Films, and Live
Entertainment. (Firestone, 2012)
Hence using leverages is both risky as well tricky venture for
any firm.
Cases to compare the usage of high debt and low debt
company there uses pros and cons .
Case Background two companies:
Name: Southern California Edison (SCE)
Parent Company: Edison International
CFO: Alan J. Fohrer
SCE is a monopoly franchise that provides electricity to its
customers. The major part of the company consists of Debt.
Data:
Name: Southern California Edison (SCE)
Parent Company: Edison International
CFO: Alan J. Fohrer
SCE is a monopoly franchise that provides electricity to its
customers. The major part of the company consists of Debt.
Data:
Name: Southern California Edison (SCE)
Parent Company: Edison International
CFO: Alan J. Fohrer
SCE is a monopoly franchise that provides electricity to its
customers. The major part of the company consists of Debt.
Data:
Name: Qualcomm
CFO: Anthony S. Thornley
Quallcomm is a supplier of digital wireless communication
products and services . Is capital structure as nil debt.
Data:
Outcome and Learnings.
SCE is operating in low competition with stable revenue
stream and the CFO considers Debt is as tax deductible
source of funding and hence it could be used for advantage
but this data is of year 2000 whole sale electricity prices
rised .Standard and Poor lowered its credit rating for Edison
International and Company lost its ability of borrow but still
it has less financial distress cost due to government provided
it some assistance on other hand Qualcomm a San Diego
based company operates in highly competitive environment
with competitors such as IBM (IBM), Hewlett-Packard (HPE)
and Dell which results in increase in risk and less debt
capacity . Also the ideology of the management is
conservative they finance there growth from retained
earnings and equity moreover collateral value of intangible
assets which are major part of Qualcomm have less
collateral value . As the company’s operations strengthen
and it has steady stream of cash flows it can utilize benefits
of Debt .
So basically the firms leverage and capital structure decision
depends on the ide (Ross, Westerfield, & Jeffrey, 2004)ology
of the management , existing competition , kind of assets it
holds and cash flows. (Libert, Beck, & Wind, 2016) (Berman &
Knight, 2009)
As per annual report 2017 Qualcomm
Total
Assets 65,486

Long-term debt 19,398

Total stockholders’ equity 30,746

0.630911

As per annual report 2017 Edison debt equity ratio stands to

be 0.02 and hence ratio of both companys stands reversed. (Libert, Beck, & Wind, 2016)
Bibliography
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https://www.bloomberg.com/opinion/articles/2018-04-17/johnson-johnson-earnings-fine-for-now