Question

Is the following statement accurate? Please provide a numerical reasoning to support your claim. A firm that is debt-using with a negative leverage gain will always have a return on equity that is negative.

Answer 1

If Return on Investment is less than cost of borrowing(negative leverage) then there will be erosion of Net worth (ie equity)

Eg suppose I borrow $100,000 @10%pa and invest the same in a project that earns me a return @ 5% see what happens

CF from project $105,000

Less Interest $10000

Balance $95000

Less Principal Repayment $100,000

Decrease in my net worth $5000

ie negative Equity means I have to break my FDs in order to pay off this liability and therefore my net worth is eroded to the tune of $5000

higher the borrowing higher the erosion of networth (if Return on Investment is less than cost of borrowing)