Question

How does a firm “leverage” its capital structure? When is leverage advantageous? When is it disadvantageous? Who receives the advantage or bears the disadvantage of leverage? Describe how recent rule changes will require leases to be accounted for beginning in 2019. How do the old lease accounting rules differ from the new lease accounting rules? How do the new lease accounting rules impact leverage?

Answer 1

Leverage in capital structure means the use of borrowed funds.

Firm "leverage" its capital structure in the following way

1) Taking term loan from financial institutions

2) Issuing Debentures

3) Issuing Bonds

4) Issuing commercial paper

5) Taking working capital loan in the form of OD/CC

These are some of the ways to leverage capital structure

The advantage of Leverage:

1) It increases EPS and returns on equity

2) Leverage is cheaper as the cost of debt is always lower than the cost of equity

3) Leverage helps in controlling the dilution of control of equity as if the same fund is raised through equity it may lead to dilution of control

Disadvantages of leverage:

1) Leverage increases the financial burden on the company as there is a fixed payment to be made every year

2) The company will have to meet the obligations irrespective of financial position

3) Debt holders are paid first in case of dissolution of the company, equity holders are paid at the last which may be disadvantageous for them