Question

Which of the following are typically benefits of the use of debt financing? It may allow...

Which of the following are typically benefits of the use of debt financing?

It may allow investors who are capital constrained to increase their returns.

It may allow investors who are capital constrained to diversify their holdings.

All listed are likely benefits.

It may allow investors who are capital constrained to leverage their human capital.

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Answer #1

Answer: Option 1

Reason: Debt financing involves the use of fixed cost capital to increase the earning of shareholders, providing them with financial leverage. Increase in earnings before interest and tax(EBIT) enables higher earning before tax(EBT) only when the capital charges are fixed.

Example:

Case I

EBIT= 200000

Interest on Debt=5000

EBT=200000-5000

=195000

Case II

EBIT= 300000

Interest on Debt=5000

EBT=300000-5000

=295000

This increase in EBT is possible only when the cost of capital remains fixed, leaving morefor the shareholder from the increased EBIT.

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