Question

In: Finance

What is the potential impact of more debt or financial leverage in a businesses capital structure...

What is the potential impact of more debt or financial leverage in a businesses capital structure on Net Income, Earnings Per Share and Return on Equity?

Solutions

Expert Solution

Debt and ROE

Increased debt increases the leverage factor in a company. During normal or boom times, leverage results in exponential profit returns. During recessions, leverage can result in exponential losses, as well. A large debt burden carries risk because of the reaction of leverage to the prevailing economic conditions. Increased debt favors ROE during boom times but hurts ROE during recessions.

While debt does not dilute ownership, interest payments on debt reduce net income and cash flow. This reduction in net income also represents a tax benefit through the lower taxable income. Increasing debt causes leverage ratios such as debt to equity and debt to total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet certain interest coverage and debt level requirements. In the event of liquidation, debt holders are senior to equity holders.


First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all.

Thanks


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