Question

what is the effects of long-term debt on a firm’s capital structure. how does increasing the use of debt might affect the firm’s overall cost of capital, stock price, and earning per share?

Answer 1

Long term debt will be providing the company with the additional flexibility to sustain in the long run by taking the loan funds and paying interest on them which will be tax deductible and reduce the overall cost of capital of the company.

When there would be a larger proportion of long-term debt into the overall capital structure of the company, it will mean that the company is having a large amount of solvency risk if it is not generating enough cash to repay the loans, and it should also have a higher amount of assets in order to square off the loan.

Since these loan capital have a payment related to interest,interest are generally tax deductible in nature and that would be lowering the cost of debt and that would be resulting into lowering down cost of overall capital. When there is a lower rate of return on investment, then lower debt should be preferred, because the cost of capital will get higher because of more debt capital.

when there would be a large amount of debt into the firm structure, it will mean that shareholders are sceptical about the solvency of the company and they will be pushing the share price down by dumping the share because they feel that there is an insolvency risk attached to the company.

Earning per share will be increasing if the cost of capital is lower than the overall rate of return, but if the cost of debt is higher than the rate of return than it would be leading to decrease in earning per share.