Question

Trudy Pierre is the CFO of Vista Intl, a young financial software platform firm. Ms. Pierre is considering several projects in newly opening markets in Khazaksthan. She believes that her firm should take advantage of the current low interest rates. Thus, she would like to increase the debt equity ratio of the firm but is concerned about the consequences of increasing leverage. Although she studied finance in her MBA program, she does not remember much about capitol structure theory. Knowing that you have recently taken a class, what advice would you give her?

Answer 1

The consequences that Trudy Pierre might have to face if she increases the debt equity ratio are as under-

1) Reduced Ownership Value

High debt-to-equity ratio generally reduces the value of owners’ stake in a business. For example- If your business has a high debt-to-equity ratio and you sell or liquidate the company, you would have to distribute a larger portion of the proceeds to creditors than if you had a low debt-to-equity ratio.

2) Trouble Obtaining Additional Financing

Banks require low debt-to-equity ratio while lending credit. This is because a high debt-to-equity ratio reduces a bank’s chances of being repaid, it might refuse to provide additional funding or might give you money only with unfavorable terms.

3) Increased Risk

The risk of defaulting ( being unable to repay your debt ) increases as your debt-to-equity ratio rises. A reasonable amount of debt can help you grow your small business, However, too much can overburden you with high interest payments.

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