Question

At one of their regular executive meeting, the Startco's CEO was reviewing the Company's financials and ask the CEO (which is you) the following question. "I noticed our capital structure Debt/Equity ratio is 0.33. What may happen if we double our borrowing and use the extra cash from the loan to buy back some our shares? I see doing is as a simple way to improve profitability."

Briefly explain whether you agree with the CEO statement and why (why not).

Answer 1

Leverage results from using borrowed capital as a funding source when investing to expand the firm's asset base and generate returns on risk capital. Leverage is an investment strategy of using borrowed money—specifically, the use of various financial instruments or borrowed capital—to increase the potential return of an investment.

How does leverage has an impact on profitability?

Interest paid on debt is tax deductible. Hence it reduces the tax component of income statement. As debt is used as part of finance, overall equity involved in the business will be lower, hence overall return of equity is improved, thereby improving the profitability. One more thing should be kept in mind is that more debt means the risk of default is also higher. As the default risk moves upward, the interest ask might increase by the lenders, therby the debt advantage from more debt will start diminishing. Hence arises a need to strike a proper balance of debt and equity such that the profitability is the maximum.

Hence we may agree with the CEO statement but further analysis needs to be done whether the optimal capital structure is maintained post taking of further debt such that profitability is maximised.