Question

As you know, interest rates are very low these days. Furthermore, for our firm, the cost of debt is much lower than the cost of equity at the moment. Does this mean that if our firm increases financial leverage (measured by “debt-equity ratio”) via capital restructuring, our profitability (measured by “Return on Equity”) will increase, and therefore our firm value will go up?

Answer 1

it doesn't mean that the increase in financial leverage will always result in increase in return on equity because when the interest expenses of the debt increases due to increase in financial leverage it will result in "lesser Earnings before tax" which in turn result in lesser Net income and thereby lesser Return on equity.

This is the main reason behind companies looking for optimal capital structure of Debt and Equity. Optimal Capital structure is value of debt and equity where the ROE is higher.

Thus the statement to say that ROE will increase with increase in financial leverage is false.

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