Question

Provide an example of a company that is debt adverse, but could drive additional earnings by increasing their debt load.

Answer 1

Debt adverse means that a company does't want debt component in its capital structure.

Let X Inc. is a company having 10,000 equity shares of $10 each. So the equity capital is $100,000. Assume it has a profit of $200,000.

Earnings per share (EPS) is the most appropriate factor to measure the actual earnings that are getting by the shareholders.

EPS of X Inc. = Profit available to equity shareholders / no. of shares = $200,000/ 10,000 = $20 per share

Suppose now it has decided that its capital structure should consist of debt component.

Assume that X Inc. wants its capital structure to consist 20% of debt capital.

So the company has taken $20,000 loan ($100,000 * 20%) at interest rate of 10% per year.

So the equity capital = $80,000 (8,000 shares at a face value of $10)

Interest payment per year = $20,000 * 10% = $2,000

Given Profit = $200,000

Profit available to equity shareholders = $200,000 - $2,000 = $198,000

Now, the EPS of X Inc. = Profit available to equity shareholders/ no. of share = $198,000/ 8,000 = $24.75

Though the firm is debt adverse, it can get additional earnings if it includes debt component in its component. In the present example without the debt component the company' EPS was $20 but after including the debt component the company's EPS was $24.75.