Question

Explain the effect of D/E on asset returns, equity returns (assuming that cost of debt is not affected), asset beta and equity beta (assuming that debt beta is zero). Should an investor choose to invest in a stock of a company with high or low D/E, or why expected returns on these stocks are equivalent, although they are not equal?

Answer 1

The three factors of production are considered as of the primary importance. They are land, labor and capital. The firms need capital to expand, to run operations and this capital is either raised through shareholders by issuing equity or through financial institutions in terms of debt. The debt requires payment of interest and equity needs payout of dividend.
The dividend will be paid out to shareholders only if the profit is generated but the interest of debt is obligatory and the firm will have to pay that even if it is not generating profit. The debt, however, provides tax benefit also.

There is no perfect solution about which company to choose but investors generally prefer low debt company or zero debt company. This is because it can generate a higher level of free cash flow to shareholders which higher return for shareholder value but capital intensive companies such as power, aviation, steel and automobile prefer debt financing with 70% to 80% debt. As mentioned earlier, debt provides tax benefits and equity financing tends to costlier in the long term.