Effect of debt on various ratios
Through acquiring more debt and repurchasing stocks, book value per share decreases due to premium paid for repurchased stocks. More debt would also bring more interest expense to Hill Country, which lowers net income. Considering total asset value would remain same, return on assets (ROA) would decrease as a consequence of lower net income. The spreadsheet also shows that return on equity (ROE) would increase as debt capital ratio increases. Sensitivity analysis shows that with a 10% and 20% reduction in EBIT respectively, net income drops more than 10% and 20% in each of the three scenario, with the largest reduction in 60% debt to capital scenario. Benefits of debt financing
Financing with debt could increase ROE. Also, financing with less equity could take the advantage of cheap debt financing which has low interest rate. Further, stock price would go up as a result of less shares outstanding therefore previously undervalued stocks would be valued at a more reasonable price. Additional stock value from debt financing
With a debt-to-capital ratio of 20%, 40% and 60% respectively, the additional value per share is $4.49, $6.22 and $3.33. Risk
This projection tells us that adding debt to capital structure could lower our risk at the beginning. This is because debt could increase our financial leverage and cost of financing with debt is lower than financing with equity. As debt portion grows to some point, so does the risk of default. Investors start to worry about not getting their money back and ask for more compensation for taking the extra risk. Optimal point
Our calculation shows that the optimal point occurs at 40% debt to capital ratio, where stock price reaches $47.9, the highest among three scenarios.
The cost of financial distress is mainly reflected by the increasing yield to maturity (YTM) on bonds with lower ratings. To compensate bond investors the increasing amount of default risk, companies have to pay a...
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