Leverage is the use of borrowed capital or debt by a firm to fund its operations and generate returns. It may either be financial leverage or operating leverage. Firms in the REITs, paper products companies, airlines, and electric utilities prefer to have high leverage. To maintain their operations, such firms require financial leverage (Alcock, Baum, Colley, & Steiner, 2013, p. 84). The airline industry, for example, has high leverage because due to the competitiveness of the industry. An airline company cannot afford to lack funds for operations. If an airline company wants to buy a new airplane due to increased demand, it will seek a loan for acquiring the plane. It is because the airline company expects to earn enough revenues from the acquisition of a new aircraft which will aid in settling the debt. Furthermore, as a result of having high fixed costs, an airline company benefits massively from high operating leverage. However, it is important to note that high leverages or excessive debts are risky and may lead to bankruptcy.
Companies in computer hardware, data processing, luxury goods, and footwear industries prefer to have low leverage. It is because such firms are small when compared to highly leveraged companies and have not been in business for long. A computer hardware firm, for instance, may have a considerable supply of cash which it relies on for self-financing. Being small in size, the company would prefer to fund itself because it can be able to afford the operational costs (Strebulaev & Yang, 2012, p. 11). Additionally, most of these firms are less independent and are self-owned which means that they do not have any pressures from shareholders. Furthermore, these firms are owned and controlled by conservative CEO’s who prefer to have minimal debts and hence have low leverage.
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Firms decide to increase their dividends or repurchase stocks due to certain factors. Firstly, a firm may make a large increase in dividends if it experiences a substantial increase in net profits. If a firm earns more profits than it had anticipated, it will increase the dividends of shareholders and investors in the firm. Also, if there is political uncertainty in a region, a firm may choose to make substantial increases in their dividends because it will convert investment funds to dividends. Furthermore, if a firm lacks investment opportunities, it would choose to increase its dividends. However, a firm may also choose to start a stock repurchase program if it wants to consolidate its ownership. By buying back its stock or shares, a firm reduces the number of market shareholders. This, in turn, increases the stake ownership of investors because there are fewer company shares in the market (Pirgaip & Karacaer, 2017, p. 65). Other factors such as the reduction of capital costs and undervaluation of a firm’s stock market may also make it choose to start a stock repurchase program. A firm would choose to buy back its stock over making large dividend increases to reduce its market ownership which would translate to more stock ownership for investors.
Lastly, firms decide to remove or cut dividends due to factors such as a downturn in the earnings, lack of funds to settle dividends or a change in a firm’s dividends policy (Floyd, Li, & Skinner, 2015, p. 302). If a firm’s earnings are weakening it may choose to cut or eliminate dividends because it can no longer be able to cover them. More so, if a firm does not have enough funds to settle dividends, it may choose to eliminate or cut them. Ultimately, if a firm’s dividends policy has been changed and it decides not to give out dividends, it will decide to eliminate them. When a company cuts or eliminates its dividends, the stock price is negatively affected. It is because investors assume that the firm is struggling financially which may make them sell the shares of the firm or avoid investing in the firm.
References
Alcock, J., Baum, A., Colley, N., & Steiner, E. (2013). The role of financial leverage in the performance of private equity real estate funds. The Journal of Private Equity , 80-91.
Floyd, E., Li, N., & Skinner, D. J. (2015). Payout policy through the financial crisis: The growth of repurchases and the resilience of dividends. Journal of Financial Economics , 118 (2), 299-316.
Pirgaip, B., & Karacaer, S. (2017). Why Do Firms Repurchase Their Stocks? Evidence from an Emerging Market.
Strebulaev, I. A., & Yang, B. (2013). The mystery of zero-leverage firms. Journal of Financial Economics , 109 (1), 1-23.
