Question

Leveraging in an organization:

Do you know of a situation in which a company has used debt to their advantage? If so, could you please tell me how and how did it work in their favor?

Answer 1

In past time, we have seen that many companies have used debts in their financial structure for improving earning per share (EPS), for improving overall wealth and for improving overall value etc.

Now let’s take an example of Berkshire Hathaway Inc. This company used debts funds in its capital structure. This company raised finance with the help of debt, we also know that debt provide leverage effect to a company. We can also see effect of this debt on the financial statement, income statement etc. With the help of debt funds net income & EPS have improved hence we can say that with the help of debt this company have enjoyed some positive results.

Now let’s know how use of debt can generate some advantages?

Use of debts can generate advantages due to following reasons;

1. Interest on debt is tax deductible hence net profits after tax will be higher for a firm & company that is why company prefer to use debts in the financial structure.

2. With the use of debt funds, number of outstanding shares will be lower hence earning per share (EPS) will be higher because as number of outstanding shares will be less then available profits will be distributed amongst less number of shares.

3. If interest on debt is lower than expected return on equity then use of debts will generate some advantages for a firm because firm have to pay less amount of interest on debts in compare to normal return on investment.