Question

Leverage Sensitivity Exercise

View table below of baseline profits:

	Profits from Operations Unchanged
Total Debt	$ 14.00	$ 18.00	$ 22.00	$ 26.00
Total Equity	$ 59.00	$ 55.00	$ 51.00	$ 47.00
Profit From Operations	$ 14.00	$ 14.00	$ 14.00	$ 14.00
Interest Expense (6% of Debt)		$ (1.08)
Net Profit Before Taxes		$ 12.92
Taxes (38%)		$ (4.91)
Net Profit After Taxes		$   8.01
Debt to Equity Ratio		0.327
Return on Equity		14.56%

Based on these numbers, calculate:

A) Profits from Operations Up 30%

B) Profits from Operations Down 40%

C) Comment on performance of the company across the various capital structures at differing levels of profit and choose which is better.

Answer 1

PARTICLUARS	I	II	III	IV
TOTAL DEBT	$14	$18	$22	$26
TOTAL EQUITY	$59	$55	$51	$47
TOTAL FUND	$73	$73	$73	$73
			[IF UP 30%]	[IF DOWN 40%]
PROFIT FROM OPERATIONS	$14.00	$14.00	$18.20	$8.40
INTEREST EXP. (6% OF DEBT)	($0.84)	($1.08)	($1.32)	($1.56)
NET PROFIT BEFORE TAXES	$13.16	$12.92	$16.88	$6.84
TAXES (38%)	($5.00)	($4.91)	($6.41)	($2.60)
NET PROFIT AFTER TAXES	$8.16	$8.01	$10.47	$4.24
DEBT TO EQUITY RATIO	0.237	0.327	0.431	0.553
[ DEBT/EQUITY]
RETURN ON EQUITY	13.83%	14.56%	20.52%	9.02%
[NET PROFIT AFTER TAX/EQUITY*100]

A high debt-equity ratio can be good because it shows that a firm can easily service its debt obligations (through cash flow) and is using the leverage to increase equity returns.

A second issue that could cause a high ROE is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt.

OPTION THIRD IS BETTER DUE TO HIGHER ROE (RETURN ON EQUITY) BUT DEBT EQUITY RATIO ALSO INCREASE.

IN MY OPINION IF COMPANY HAS LOWER DEBT IS FUNDAMENTALLY STRONG (OPTION-II). A COMPANY HIGHER ROE IS NOT BETTER IF DEBT IS HIGHER.