Financial leverage means acquiring assets using funds provided by creditors and preferred stockholders to improve Return on Equity (ROE) of a company rather than utilizing owners’ equity. If a company can borrow money at a rate lower than the return on assets or ROI then the owners' equity position will be improved. This occurs because less of the equity is required to purchase the assets. It is a double-edged sword and may be positive or negative.
• A positive financial leverage is a position when the assets acquired using borrowed funds generate a rate of return that is higher than the rate of interest or dividend payable to the providers of funds. It is beneficial for common stockholders. E.g. …show more content…
will be worse off by 1.1% per dollar spent and $0.07 per share under the probable new capital structure of $600,000 in debt financing compared to the current capital structure that is all-equity.
• Parpu Corp.’s CEO should not add this much debt to the firm as it would not benefit the shareholders of the company.
• The CEO might look at smaller amounts of debt to determine if debt can be valuable as smaller amounts of debt might lower the cost of debt borrowing and make leverage value-enhancing for the shareholders.
• However, even with smaller amount of debts would not generate a better ROE and EPS for Parpu Corp, as compared to its current zero debt capital structure, if other conditions like EBIT, interest expense, and corporate tax remain similar to their current positions of (ceteris paribus).
• Moving from one source of funding to another in a particular order is called the Packing Order Hypothesis, which predicts firms prefer internal financing first, if external financing is required, firms should first seek debt financing, and if external financing is required, firms will choose to issue the safest or cheapest security first, starting with debt financing and using equity as a last