Question

How does financial leveraging through bonds enable a firm to thrive and expand?

Answer 1

Financial leverage is ability of the firm to use fixed cost of capital to magnify the effect of changes in EBIT. Financial leverage involves the use of funds obtained at a fixed cost in the hope of increasing the return to equity shareholders it results from the presence of fixed financial charges in the firm's income streams.

Financial leverage through bonds provides firm tax advantages in interest payment. Issuance of bonds involves payment of interest and tax is saved on the payment of interest. So, if the interest rate on bond is say 10% and tax rate is 30% then effective rate of interest will be 10%*(1-0.30) = 10%*0.7 = 7%. Financial leverage through bonds reduces the overall cost of capital of the firm and it enables the firm to expand.