Question

Over the next few years economist expect that the next financial bubble might be the high debt of organizations bursting. A. Explain the difference between highly leveraged firms and low leveraged firms in regards to fixed and variable costs B. What are the benefits of being highly leveraged and the downfalls. C. Explain the benefits of being low leveraged firm and the potential downfalls.

Answer 1

A. High leveraged firms are the firms having high portion of debt financing in the total capital structure. While low leveraged firms are those firms who have a high proportion of equity financing in their capital structure and they do not use much of of debt in their overall operations.

Fixed costs related to interest charges for highly leveraged firms are always high , while low leverage firms do not have such fixed obligation to pay interest on their debt. Variable cost related to both kinds of firms are almost similar. So there is always a cost advantage for low leveraged firms because they have no fixed obligation for periodic date repayments.

B. When the cost of debt is lower than the overall return of capital the firm,it is able to capitalise on the debt and hence debt helps in overall growth of the firm.

When the cost of capital is higher than the cost of debt it minimises the overall profit of the firm and minimises the growth prospect of the firm also.

When the firm is not able to meet its periodic debt repayment obligations creditors may drag it to insolvency courts and hence the existence of the company maybe endangered due to default on repayment of debt.

C. Low leveraged firms do not have any fixed obligation to pay that so,at the times of adverse economic situations they are preferred because they are able to survive. When the economy downturns, such firms are able to capitalise and gain more of the market share because the competition is less as the leveraged firms cant sustain. Thus, it helps in overall growth of the firm.

The limitations related to low leverage farms is that they are not able to grow on credit and they can get outdated because of sticking to traditional methods of capital structuring. Lack of debt will result in lack of expansion and growth for the firm.

So Debt is a double edged sword and it should be utilised effectively.