How much Debt should be Borrowed
If a person wants to buy a car that costs $10000. He decides to make and down payment of 60% or $6000 and asks a bank to finance the remaining 40%. The bank is quite willing to enter into the deal, since it holds a car valued at $10000 as collateral for its $4000.
This is a basic example of how a company would think in terms of raising finance through equity and debt. If the owners of the company provide all the finance and don’t rely on debt, then we can say the firm is an all-equity or an unlevered firm. On the other hand, a firm that uses debt financing is a levered firm. The more debt a firm has, the greater its financial leverage. Financial leverage is the use of debt to multiply the effectiveness of equity. Leverage can improve good results – or it can worsen results that are already poor. If we use it properly, financial leverage can be effective in improving financial performance. But there is a disadvantage: when we increase financial leverage, we increase the risk for the firm.
An all equity firm can borrow money by buying some of its shares back from shareholders, it has restructured its capital to include more debt.
|Before Restructuring||After Restructuring|
An enterprise may restructure in this way if it believes that
It will improve the financial performance of the firm, or
The share is undervalued in the market.
How does the debt-equity mix affect the performance of a firm
We measure the performance of a firm by the ratio of net profit to equity. This ratio is called the return on equity (ROE) and is determined by dividing the net profit by the equity listed on the balance sheet.
ROE = Net profit/ Equity
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