Question

how do you determine how much leverage is too much leverage?

Answer 1

Leverage has certain benefits such as saving tax on the interest paid on the debt and that the leverage lowers the overall cost of capital. However, if leverage increases beyond a certain point, then other costs increase. One such cost is the bankruptcy cost. If a firm is highly leveraged, it may be difficult to meet the debt obligations, especially during bad times. The firm has to pay interest regardless of whether it is making money. So, in this case, the leverage is too much. This decreases the value added to the firm and the costs outweigh the benefits.

So, the optimal capital structure is found by finding the level of debt that when considered the costs and benefits lowers the overall cost of capital, thereby increasing the value of the firm.

Can you please upvote? Thank You :-)