Question

3. What are some potential advantages and disadvantages of operating with a high leverage and debt ratio? (7)

4. Explain why P/E ratio and EPS are used in determining health of a stock? Is it good to have a low EPS ratio? Why or why not? (8)

Answer 1

a) Advantages of high leverage and Debt ratio

· Net income increase when sales grow

· Interest is tax deductible and hence lower expenses

· The cost of debt is lower than cost of equity and hence return on equity will improve

Disadvantages of high leverage and Debt ratio

· High fixed costs impact of interest expense

· Profits decline when sales decline and may lead to losses

· Cash flows will be affected due to higher interest payments and schedule debt repayments

· Affects the solvency of the firm when cash flow is poor

· A higher ratios is not seen favorable by external parties and will affect the reputation of the firm

b) EPS is the net income of the firm expressed on a per share basis. It is calculated dividing the net income by outstanding common shares. P/E ratio is the price earnings ratio which commands the market price in the market based on Earning per share. So market price per share= EPS * P/E ratio. If the P/E ratio of the firm is lower than its peers in the industry it is lower valued and hence there is potential for the firm to grow its market share price. The EPS is one of the important ratios monitored by shareholders. The higher the Earnings per share it is better for shareholders since it will have direct impact on the market price of the firm.

P/E ratio is often used across industries for benchmarking on valuation of the firm. It is often used in the business valuation model by analysts and a key determinant of the market value of the firm. A firm should have higher EPS ratio which helps in growing the shareholders’ wealth.