Question

How does a firm's financial leverage affect its profitability? Its level of risk?

Answer 1

Financial leverage will be impacting the profitability of the company to a large extent because financial leverage will be having a benefit associated with them in form of interest tax deduction because interest which are paid to the debt holders of the company will be tax deductible in nature and it will be leading to a lower cost of debt, but it will also mean that there will be a cost of financial distress which is attached to the debt capital and it is resulting into a risk associated with the solvency of the company.

we will take in the perspective of comparison of the cost of debt with the overall return on capital and if the overall cost of debt is lower than the return on capital, it will mean that the company is generating excess rate of return and it would be leading to a higher rate of return on equity for the company so it will be generating growth for the company

When the return on capo would be lower than the cost of debt it will mean that the company should cut on the overall debt capital because it is leading to lack of growth for the company and it is living to reduction of return on equity

Hence there should always be a comparison between the the debt capital in respect to the overall rate of return and the ability of company to maximize the benefit of the debt capital in order to extract a higher rate of return so that there would be a higher return on equity for the company and if the company is not able to generate a higher return on capital then, it should not be loading up with higher amount of debt capital because it can lead to a higher amount of solvency risk and eventually leading to higher financial distress cost.

Higher amount of financial leverage will be increasing the risk associated with the insolvency of the company so there should always be a proper trade off between the benefits of interest tax deduction and cost of financial distress