What is the effect of debt on firm profits?
Debt financing can also increase returns because interest is generally tax deductible. This means that firms are able to get more for their money when they use this method as opposed to investing with only cash.
There are also some negative aspects to leverage. One of the downsides of higher debt levels is that they can increase earnings volatility, as firms are required to pay regular payments to service these liabilities despite how well their finances perform (which may put pressure on budgets in downturns). In addition, bad decisions when leveraging could lead to a company being overleveraged. This would make it unable meet their obligations and may even put strain on budgets during downturns.
Leveraged investments, when managed properly and closely monitored can bring businesses tremendous rewards. However, if they are mismanaged then there can be big risks. It is therefore important that companies who are considering this option carefully weigh all the potential effects before taking any decisions.
If a company needs to begin with $100, it will have the following requirements:
Sales$200
Expenses$185
Tax rate 33% of earnings
a. What is the profit if firm owners invested the $100 without using financial leverage? The tax values and the net earnings should be rounded up to two decimal points.
b. If the firm borrows (utilizes financial leverage) $40 of the $100 at an interest rate of 10%, what are the firm’s net earnings? The tax value and the net profit should be rounded up to two decimal points.
What is the equity return when you use financial leverage and do not? Why are there differences in the returns? ROE values should have 2 decimal points.
For each case, what is the updated return on investment value if costs increase by $194? The ROE should have 2 decimal places.
Was the return on investment lower when leverage was used or not?
f. How does the use of financial leverage effect a firm’s earnings? Financial leverage is beneficial when used in the right circumstances. When does it become a disadvantage?
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