Question

Discuss four risks that your company is likely to be exposed to if it goes ahead with debt finance as a source of finance and explain with 5 points how this decision will affect the return to the equity holders or shareholders of your company (hotel) following the arguments of M&M proposition 2.

Answer 1

Risks in debt financing:

Emplying more and more debt as a source of finance by a Business leads to an increase in the Financial leverage of the Company leading to higher financial risk.

When a Firm takes on debt, it becomes an obligation to pay interest on that debt periodically at a fixed rate to the bond holders. This is a fixed charge which the Firm has to pay irrespective of the level of profits it earns in a year, unlike the equity dividend which is distributed from profits. A Firm generally takes higher levels of debt when it expects that the return earned on assets will be more than the interest paid on loan.

The main risk associated wuth employing high levels of debt in a business is that the return on assets (ROA) might not exceed the interest on loan. This leads to diminishing return on equity and profitability of the Company.

How this decision will affect the return to the equity holders or shareholders of your company:

M&M 2nd Proposition states that there exists a direct relationship between the cost of equity of a company and its financial leverage levels:

re= ra + D/E (ra-rd)   

Where:

• rE = Cost of levered equity
• ra = Cost of unlevered equity
• rD = Cost of debt
• D/E = Debt-to-equity ratio

An increase in the level of debt employed in the business leads to higher leverage, making the Company more risky and prone to lower return on equity.

Hence, equity investors tend to expect a higher cost of equity (return) as a compensation/premium for the additional risk taken.

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