Question

Many corporations finance at least a part of their operations and asset purchases using debt, principally because the cost of debt financing is cheaper than equity financing. Moreover, some firms are able to use leverage more effectively than others-that is, the returns to shareholders as a result of financing with debt are higher for some firms than for other firms. Using the ROE model, discuss when the use of financial leverage is most effective and least effective. When should a firm stop using debt to finance its operations or asset purchases?

Answer 1

Return on Equity (ROE) is the method of measuring of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage . ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate (1 – dividend payout ratio) as per information given.

Return on Equity is a two-part ratio for calculations in its derivation because it collectively brings together the income statement and the balance sheet, where net income or profit is compared to the shareholders’ equity. The number represents the total return on equity capital and shows the firm’s ability to turn equity investments into profits. on the other hand  it measures the profits made for each dollar from shareholders’ equity.

ROE = Net Income / Shareholders’ Equity

How to Use Return on Equity

Some industries want to achieve higher ROEs than others, and therefore, ROE is most useful when comparing companies within the same industry or in similar form. Cyclical industries tend to generate higher ROEs than defensive industries, which is due to the different risk factors ,characteristics attributable to them on different basis. A riskier firm will have a higher cost of capital and a higher cost of equity

so, it is useful to compare a firm’s ROE to its cost of equity. A firm that has earned a return on equity higher than its cost of equity has added value for the financial structure. The stock of a firm with a 20% ROE will generally cost twice as much as one with a 10% ROE (all else being equal).

Using the ROE model, discuss when the use of financial leverage is most effective and least effective. When should a firm stop using debt to finance its operations or asset purchases?

leverage is most effective

• Powerful access to capital in financial structure. Financial leverage multiplies the power of every dollar you put to work for the comapany in their financial structure. If used successfully, leveraged finance can achievemore than you could possibly achieve without the injection of leverage in their financial structure.
• Ideal for acquisitions, buyouts. Because of the additional cost and risks of bulking up on debt, leveraged finance is best suited and actualised for brief periods where your business has a specific growth objective, such as conducting an acquisition, management buyout, share buyback or a one-time dividend etc,.
• Tax benefits- whenever company wants to avail tax benefits and deduction facility then this mothod is helpful.then financial leverage is most effective.

limited finance- whwnever company involved in financial crisis then leverage is best because its cost is less.

least effective.

• Risky form of finance. Debt is a source of funding that can help and provide facility  a business grow more quickly. Leveraged finance is even more powerful then others, but the higher-than-normal debt level can put a business into a state of leverage that is too high and out of handle problem which magnifies exposure to risk.
• More costly. Leveraged finance products and services, such as leveraged loans and high yield bonds, pay higher interest rates to compensate investors for taking on more risk is down in situation .

Complex. The financial instruments includes, such as subordinated mezzanine debt, are more complex. This complexity calls for additional management time,risky factors and involves various risks.

Deciding Factor ?(When should a firm stop using debt to finance its operations or asset purchases?)

• Do you have a temporary financial need or permanent or are you facing a special situation on seasonal basis like covid situation , such as a buyout or an acquisition, in which you need an unusually large amount of money briefly?
• Are you comfortable with the increased cost, complexity and risk of this form of financing and hedging factor also?

• it really mean of timely interst paying are you compatible or not?

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