Question

13.22. Does increasing leverage (borrowing a larger fraction of the property value) usually primarily increase the expected income component of the return or the appreciation component? Why? (Hint: Use the WACC formula and assume that Elgol is usually either zero or negative, less than E[8P], while Elyo] is usually positive and around the same magnitude as E[yp].]

Answer 1

Yes, the increase in financial leverage usually primarily increase the expected income component of the return or the appreciation component because of the interest tax shield which the interest expense enjoys over the Dividend expense. The cost of debt is always comes out to be less than the cost of equity or cost of capital and the corporate are using the financial leverage or Debt component of financing to increase the company’s profit.

The level of the financial leverage is always depend on the industry’s return on capital or WACC, higher the return more would be the financial leverage as more scope to pay fixed interest of Debt. Because of the higher return on capital, the industry like airlines, grocery stores, banking, utility companies and retail stores are used to operate at higher degree of financial leverage. These industries carry a higher percentage of debt component in their capital structure.