Question

Explain how the use of leverage can increase shareholder's wealth?

Answer 1

Leverage can increase Sharesholder's wealth.

When a company employs debt, it has to pay interest on it. The interest paid on debt is a tax deductible expense and therefore liability on income will be reduced by interest cost.

The net income left with company is distributed as dividend to shareholders.

Also the debt used to acquire assets generally give return more than the cost of debt, thereby increasing profit.

Sharesholder's return is measured by Return On Equity (ROE), which is Net income divided by Sharesholder's equity.

When Net income increase, it is quite obvious that ROE will also increase. Thus Sharesholder's wealth increases.