What are the potential advantages and disadvantages to a company’s shareholders if
the company increases the proportion of debt in its capital structure?
Increase Earnings per share if return on assets exceeds cost of debt.
Benefit tax deduction from debt ie M &M theory V (l) = V (U) + Tr x Debt
BUT
Increase level of financial risk
Legal obligation
Financial Distress
Distinguish between: business risk, financial risk and default risk.
Business Risk – the risk of future net cash flows attributed to the nature of the
company’s operations. It is the risk shareholders face if the company is
financed only by equity
Financial Risk – the additional risk borne by shareholders because of the
use of debt as a source of finance
Default Risk – The chance that a borrower will fail to meet obligations to
pay interest and principal as agreed