Question

Discuss events (specific and general) which would be likely to encourage a company to raise its target debt ratio.

Discuss each question thoroughly using essay format and/or mathematical theorem where you deem necessary. Answers may be written or typed; answers should not exceed ½ page in length.

Answer 1

When firm is at growing stage it requires more capital to take up new projects then a firm can go for debt capital. Debt capital increases the leverage for the firm. As firms take up debt the return on equity is enhanced, provided the debt cost is lower than equity cost of capital.

When to encourage debt capital:

- Firm is operating below industry leverage ratios

- When firm is at growing stage and takeup more projects

- Equity capital is costly then borrowing debt

- Easy of issuing debt

- To acheive target return on equity or increasing return on equity

The debt increases the return on equity because the debt cost is generally lower than equity cost of capital. Debt basically allows a firm to take more projects with same level of equity and which finally results in higher profits.

Debt has two impacts 1) It can be charged in P&L whereas equity cost is not charged before tax 2) Debt costing gives one more impact on P&L that it is a cost and tax in not charged on debt cost.

When firms are at growing stage and equity capital is costlier than debt then a firm should go for raising capital from debt.

Debt beyond a certain limit will become a curse for company hence firm should fine tune its leverage.

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Few more concepts:

WACC represents Weighted Average Cost of Capital.

Equation:

WACC = w_dr_d (1 – T) + w_psr_ps + w_s r_s

Notations:

w_s= Weight of equity,

r_s= Cost of equity share,

T = Tax rate,

w_{d =} Weight of debt,

r_d = Cost of debt

w_ps = Weight of preference share,

r_ps = Cost of preference share,

Debt in above formula is given tax impact because tax benefits are availed by firms by charging debt to profit and loss. Hence that impact is negated here.