Limited leverage refers to the use of borrowed money in increasing the volume of
production, and thus the earnings and sales. It is measured using the ratio of the total debt to the
total assets. The higher the amount of the debt the higher the financial leverage. Limited leverage
is good for businesses for varies reasons. For instance, it enables one to retain the full ownership
of the firm. In the case study, Frank is unable to make a decision of whether to take a loan to
purchase and equipment or not. Therefore, the financial statement of the company is used in
analyzing whether it should take the loan.
Reasons why limited leverage is good for a business
It offers great access to capital
The first benefit of the financial leverage is that is robust access to the capital. If one
finances the company with the equity financing, then one has to sell the portion of ownership of
the firm (Lee, 2012). Due to this, one should work in conjunction with the other owners of the
business while making decisions. Additionally, in case one requires full management of the firm,
then using the limited leverage offers one with the option as an alternative to having the shared
If the debt is used in financing the business operations, then one will have to repay the
debt in future. Although this is a short-term financial burden, one will have to pay the debt off
(Lee, 2012). On the other hand, if equity financing instead, then one will have to share the future
profits with the other shareholders in the firm. Furthermore, the investors are not usually paid
unless the shares are bought back. (Fabozzi, 2008) Another advantage of using in financing the
FRANK SMITH PLUMBING CASE STUDY 3
operations of the business is that it offers the tax breaks. If one has to pay the interest of the
purpose of the firm, the internal revenue service enables one to deduct it on the tax return. The
amount of paid interest on the loan decreases the amount of the taxable income of the enterprise.
Therefore, due to this, it reduces the efficient cost which is related to the borrowing of funds for
It has less formality
As compared to the financing of business using equity, the use of debt is considered
more formal. When equity is used in financing the operations of the firm, then share of stocks
should be issued and hold the shareholders meeting and offer correspondence to the investors.
By comparing the two, dealing with the loan is much easier (Lee, 2012). The only requirement is
to make the loan payments on a monthly basis, and the issue is attended. Furthermore, in case
one focuses on the activities the business engage best in then leverage is considered the best
The project is profitable at the end because one will only pay the amount borrowed on a
monthly basis. Furthermore, the period given for one to pay the loan enables the individual to
work hard and repay the loan (Fabozzi, 2008). Business limited leverage is less profitable, and
this will benefit the company because it is easier to deal with a credit. The project is also
beneficial because Frank will have great access to capital. Eventual repayment will also benefit
the plumbing business. Therefore, it is evident that limited leverage is good for business. It will
also offer the owner with the chance of having share control over the firm.
FRANK SMITH PLUMBING CASE STUDY 4
Why it is unethical to call bank manger and the wife
Stephanie should convince her mother that is it is inappropriate to call the manager and
the wife for assistance in getting the approval of a loan. The mother should understand that the
banks do operate differently unlike the other businesses. Ethics is an important virtue in the
financial service industry. After the 2008 financial crisis that occurred, the banks have turned to
be very strict on the issuance of loans to the customers. Honesty and doing things appropriately
is an important virtue that Stephanie’s mother should know (Morrissey & Reddy, 2006). Calling
the bank manager and the wife may not help if Frank does not have all the required documents.
Analyzing whether the investment in truck is profitable
The investment on the truck is not beneficial according to the provided financial
statement. Frank should not proceed with the investment because it has -29,993 net present
values. Furthermore, the rate of return of the company is 9.6%, which is less than the rate that
has been projected. The profitability index of this project is 0.96, and this is less than 1.
Additionally, the discounted payback period is more than eight years, and this is the period,
which is set for the investment. The total cost of the truck is $200,000 and the present value of
the truck is -29,993. These figures indicate that the company requires a lot of capital to invest in
the track business although it is making losses. On the contrary, although the company is making
losses, after borrowing the funds from the bank, it might be able to expand its business because
limited leveraging is flexible.
Is it beneficial for Frank to close his business?
Therefore, according to the information provided, Frank should abandon the business
because it will not be beneficial in the end. He should stop the activity involving truck and
FRANK SMITH PLUMBING CASE STUDY 5
channel the money into another profitable avenue. The business involving truck will make him
continue losing money. Furthermore, he will continue using the cash that was supposed to be
invested I another avenue. Having the profitability index of less than one indicate that the present
value of the project is less than the initial investment made on the project. Therefore, the
profitability index of the company, which is 0.96, is an indication that the company is making
What to do when in a similar situation
In case I was in a similar case as Frank, then the best step to take is to abandon the
business. According to the information, it is evident that having limited leverage will not benefit
the company. Although limited leverage is important to a company, I will not benefit the
plumbing firm of Frank because of the rates of return. The net present value of the company is
negative, and the profitability index is less than one. Therefore, the best option is abandoning the
business and investing in another profitable business instead of making loses continually.
To sum up, limited leverage enables one to have a powerful access to capital. Eventual
payment and the issue of less formality are other benefits of limited leverage. According to the
case study of Smith plumbing, it is evident that the NPV and the profitability ratio indicate that
the firm is making losses. Therefore, it is beneficial for Frank to invest in another business
instead of making losses ad consuming his cash in purchasing another truck.
FRANK SMITH PLUMBING CASE STUDY 6
Lee, I. (2012). Electronic commerce management for business activities and global enterprises:
Competitive advantages. Hershey, PA: Business Science Reference.
Fabozzi, F. J. (2008). Handbook of Finance: Financial Markets and Instruments. Hoboken: John
Wiley & Sons.
Morrissey, S. A., & Reddy, P. (2006). Ethics and professional practice for psychologists.