Question

• 1. Explain in general terms the concept of return in investment. Why is this concept important in the analysis of financial performance? -

2. (a) Explain how an increase in financial leverage can increase a company's ROE.

  (b) Given the potentially positive relation between financial leverage and ROE, Why don't we see companies with 100% financial leverage (entirely nonowner financed)

Answer 1

1). Return on investment is calculated as the profit an investor earns on the amount invested. It is an important metric in analyzing financial performance because companies can use it to quantify how profitable an investment has been. So, over a period of time, it is an indicator of the success (or failure) of a business.

2). Financial leverage is described as the debt equity ratio of a company. Depending on the capital structure and cost of funding for the company, there is an optimal leverage at which the company's net income and consequently, the company's ROE will increase. As debt financing increases (upto a certain point), the tax benefit of the debt shield and hence, the net profit increase. Additionally, if the debt earns more than its cost (which is usually low for debt), it again boosts the net profit. This leads to an increase in ROE.

3). Increasing debt beyond a point can lead to risk of default as interest payments can become too big. It can be a precursor to bankruptcy, as well. Additionally, as debt increases, investors perceive the company to be riskier so overall, cost of capital for the company increases and the stock price can plummet.