Question

Suppose that you are a CEO of a local grocery chain. A large national grocery chain announced a plan to open new stores in your town. Provide a reason why you would increase the leverage and a reason why you would rather reduce the leverage. Consider both cases.

Answer 1

Reasons why we should increase the leverage.

i) leverage helps to reduce taxes

ii) lncrease in leverage increases stock volatility which in turn increases the level of risk leading to higher return on equity.

Reasons why we should reduce leverage

i) Taking on leverage will make the company more risky and difficult to borrow money. More and more borrowing will also increase the cost of borrowing.

ii) Increase in liability

iii) Increase in fixed interest to be paid per month or year