Question

In: Finance

2) By adding leverage, the returns of the firm are split between debt holders and equity...

2) By adding leverage, the returns of the firm are split between debt holders and equity holders, but why does equity holder risk increase as debt is added to the capital structure?

Solutions

Expert Solution

leverage works when we divide the capital structure into fixed and variable cost of funds. Equity holder are the variable cost of fund suppliers and actual owner of the entity. The debt holder are the fixed cost fund supplier and the creditor of the firm. When the equity holder forcast the future earning exceeding the cost of debt, they want to take the advantage of fiancial leverage. Using this leverage their cost of fund increased. And their per share earning increased. On one side this leverage can increased the income of the shareholder yet on the other side it increase the risk of defaul of payment to the debt holders. In case the firm will not earn the income above the cost of debt, then this leverage works adversaly and the per share income decrese instead of increasing. Because the firm has now fixed liabiliity of paying the interst to the debt owners. They have nothing to do with the decreased profit of the firm. So the use of finacial leverage is done when firms is assure of future earning and that too when earning rate is more than the cost of debt.


Related Solutions

Explain how the prospect of risk shifting can create a conflict between debt holders and equity...
Explain how the prospect of risk shifting can create a conflict between debt holders and equity holders.(would appreciate if you can post answers by writing down the words on web page instead of pictures in case i cannot look clearly of each words)
1. The cost of capital for a firm with a 60/40 debt/equity split, 2.93% cost of...
1. The cost of capital for a firm with a 60/40 debt/equity split, 2.93% cost of debt, 15% cost of equity, and a 35% tax rate would be 2. Complete the following sentence. The WACC _________________. Group of answer choices a. Is equal to the firm’s embedded debt cost times (1- the tax rate). b. Is directly observable in financial markets. c. Is the required return on any investments a firm makes that have a level of risk greater than...
3 (a) Sketch a graph illustrating the relationships between firm leverage and the required returns on...
3 (a) Sketch a graph illustrating the relationships between firm leverage and the required returns on equity and debt, and the weighted average cost of capital, according to the Modigliani-Miller no-taxes model. Provide an intuitive explanation of each of the relationships you have illustrated graphically. (190 words).
1.describe the agency relationship between agents and equity holders. 2.Discuss 3 agency problem associated with equity...
1.describe the agency relationship between agents and equity holders. 2.Discuss 3 agency problem associated with equity 3.Research project based on the topic of budget deficit financing in PICs?
A firm currently has a debt-equity ratio of 1/2. The debt, which is virtually riskless, pays...
A firm currently has a debt-equity ratio of 1/2. The debt, which is virtually riskless, pays an interest rate of 8.1%. The expected rate of return on the equity is 12%. What would happen to the expected rate of return on equity if the firm reduced its debt-equity ratio to 1/3? Assume the firm pays no taxes.  (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.) Expected rate of return on equity    %
Explain the effect of D/E on asset returns, equity returns (assuming that cost of debt is...
Explain the effect of D/E on asset returns, equity returns (assuming that cost of debt is not affected), asset beta and equity beta (assuming that debt beta is zero). Should an investor choose to invest in a stock of a company with high or low D/E, or why expected returns on these stocks are equivalent, although they are not equal?
1. Explain why the cost of debt and equity are expected to increase as leverage increases....
1. Explain why the cost of debt and equity are expected to increase as leverage increases. 2. Contrast and critique the use of physical and financial measures for evaluating the growth of agricultural firms.
If a firm decreases leverage (debt), what is the likely impact on the firm’s WACC?
If a firm decreases leverage (debt), what is the likely impact on the firm’s WACC?
(1) Explain the difference between debt and equity capital (2) Give 3 examples each of debt...
(1) Explain the difference between debt and equity capital (2) Give 3 examples each of debt security or capital, hybrid security or capital, and equity security or capital. (3) What are the benefits of using debt capital? (4) What are the costs of using debt capital? (5) Identify six theories of capital structure and provide brief explanation
Firm 1 has a capital structure with 20 percent debt and 80 percent equity. Firm 2’s...
Firm 1 has a capital structure with 20 percent debt and 80 percent equity. Firm 2’s capital structure consists of 50 percent debt and 50 percent equity. Both firms pay 7 percent annual interest on their debt. Finally, suppose that both firms have invested in assets worth $100 million. Required: Calculate the return on equity (ROE) for each firm, assuming the following: a. The return on assets is 3 percent. b. The return on assets is 7 percent. c. The...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT