Question

What is the potential impact of more debt or financial leverage in a businesses capital structure on Net Income, Earnings Per Share and Return on Equity?

Answer 1

Debt or financial leverage provides the benefit of reduced taxable income as the cash flows will be deducted by the interest expenses. But there is a threshold, there will be an optimal capital structure(with optimal mix of debt and equity) which increases both the Earnings and stock price, that gives minimum WACC.

Whereas, as Debt increases beyond the optimal level, the interest expenses will also increase, company may go bankrupt if it is not able pay the interest expenses. And also, the earnings will decrease and stock price will also be reduced or valued at a lesser price. So, both earnings per share and return on equity will be decreased