Question

The following table shows income and expense data under two different capital structures - 100% equity and 50% debt/50% equity. But there is uncertainty associated with the financial projects as reflected in the three scenarios presented for each capital structure. Use the information in this table to identify the advantages and disadvantages of debt and equity.

		All Equity($200k)				50/50 ($100k equity, 100k debt)
Probability	0.25	0.5	0.25		0.25	0.5	0.25
Operating income	0	75,000	100,000		0	75,000	100,000
Interest expense	0	0	0		10,000	10,000	10,000
Taxable income	0	75,000	100,000		(10,000)	65,000	90,000
Taxes (30%)	0	22,500	30,000		(3,000)	19,500	27,000
Net Income	0	52,500	70,000		(7,000)	45,500	63,000
ROE	0.00%	26.25%	35.00%		-7.00%	45.50%	63.00%
Expected ROE		21.88%				36.75%
Standard deviation of ROE		13.13%				26.25%

Answer 1

Using debt increases the ROE but also increases the variability of ROE thus using debt increases the risk of the company but using equity does not increase the risk. In case of debt, there is a fixed payment that must be made regardless whether the company is generating any profits or not. However, in case of equity no fixed payment is required and it all depends on the profitability. Using debt does not dilute the ownership of existing owners but using equity dilutes the ownership. Debt payments are tax deductible and hence net income is lowered not by full interest amount but by a lesser amount. In case of debt, as payments are known well in advance cash flow planning is easier. Interest is fixed cost and it raises company's break-even point. Debt investors are entitled only repayment of principal plus interest, and they have no direct claim on the future profits of business. If company is successful, owners (i.e., equity) reap larger portion of rewards compared to if they had ssued addiitonal equity. This is called gearing advantage.