Question

Explain how debt financing (financial leverage) could improve the value of the firm.

Explain why too much financial leverage might hurt the value of the firm.

Answer 1

Financial leverage has significant effect on firms’ value. Financial leverage reflects the amount of debt used in capital structure of the firm. Increase in leverage is positively related to the value of a firm. Financial leverage results in increase the company’s earnings per share and to increase its return-on-equity. A high level of debt relative to equity, a small percentage change in earnings before interest and tax (EBIT) will lead to a large percentage change in net income.

Financial leverage could improve the value of the firm because the use of debt financing in the capital structure ensures an increase in efficiency besides providing tax shield to the firm.

Financial leverage maximizes returns.

Financial leverage is a financial tool that is used to improve a firm’s rate of return and its value.

However, too much financial leverage, can lead to the risk of default and bankruptcy.

Too much financial leverage might hurt the value of the firm, as firms are often unable to pay their operating expenses because of excessive costs due to their debt burden, such as interest payments and principal repayments.