Question

XCV, Inc., which manufactures automobile parts for assembly, is considering the costs and the benefits of...

XCV, Inc., which manufactures automobile parts for assembly, is considering the costs and the benefits of leverage. The CFO notes that the return on equity of the firm, which is only 12.75% new based on the current policy of no leverage, could be increased substantially by borrowing money. Is this true? Does it follow the value of the firm will increase with leverage? Why or why not?

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Answer #1

SOLUTION:-

Given that value of the firm will increase with leverage then:

  • Yes, By taking debt, the company can improve its ROE. This is possible because by taking on debt, the comapny will get funds which will be used to purchase assets which will be used to generate returns hence the net income will increase.
  • Also, by taking debt the equity composition will not change hence the ROE which is given by net income / equity will increase significantly.
  • Also, the Enterprise value of the firm will increase with debt because debt is considered while calculating EV of the firm. If we talk about the equity value of the firm it wont increase because it does not take debt into account.

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