Question

1. A corporation doubled its debt holding recently. Please provide a real option-based reason why increased debt may affect the stockholders negatively.

Answer 1

A stockholder gains in 2 ways - capital gains and dividend yield.

The future earnings growth projection affects the current price of the stock and higher growth and higher earnings reflect that the company stock provides higher returns. The dividend yield depends on the net profit the company makes, and the management's decision of the retention ratio.

Increased debt leads to higher financing and interest costs. These interest costs are deducted from the operating income or in short, decrease the net profit available for the company. In such a situation, increased debt negatively affects the company's earnings and hence adversely affects both the capital gains and dividend yield for the stockholders.

Another reason being, a situation of bankruptcy. Stockholders are the last ones in priority to recover any capital in case of liquidation of the company. Hence, in this case, the chances of shareholders recovering capital reduce further, as debt holders are the first ones to be paid in case of liquidation. Increased debt may increase the probability of the company defaulting on its interest payments and hence, the expected recovery value to the shareholders in case of liquidation goes down.

Due to these reasons, increased debt may affect the stockholders negatively.