Question

What happens to a firm when it raises its debt from 0% to 10%. how does increased debt increase BEP (basic earning power)?

Answer 1

Debt Funds generally have a fixed interest rate. The cost of debt is generally less compared to the cost of raising equity. By raising debt, a company can reduce its weighted average cost of capital. The higher leverage is likely to increase the earnings per share for equity shareholders. This occurs because the company will be able to make new investments at a lower cost.

Basic Earning Power, is EBIT/Total Assets. When a Company replaces its equity with debt, total assets do not change and hence the denominator will not change. However, the EBIT is likely to get affected since the cost of capital is not lesser for the Company. As a result the Company's BEP is likely to increase