Debt has deadlines. Deadlines can be missed. Common stock lasts indefinitely. Th

Question

Debt has deadlines. Deadlines can be missed. Common stock lasts indefinitely. The higher percentage of resources raised from debt, the higher percentage resources subject to deadlines, hence risk.

Required:

What is the effect on return on equity of raising capital through debt? There would appear to be two effects: the cost of debt and the amount of debt. To respond to this question you will need to explain the relationship, ROCE = ROA x Common Earnings Leverage x Financial Structure Leverage. Explain the numerator and denominator for the ratios and how they capture the cost of debt and the amount of debt. Having extended a loan to a company, a banker uses accounting reports to evaluate compliance with the terms of the loan. Give an example of a term where accounting might play a role.

Explanation / Answer

Return on equity has a far reaching effect of raising capital through debt.

This can be explained with the following relationship:

ROCE = ROA X Earnings leverage x Fiancial leverage

Net Income - Preferred dividends / Shareholders equity = PAT/Avg Assets x Net Income - Preffered dividends/PAT x Avg Assets/Shareholders equity

If a large amount of capital is raised through debt :

Net income available to equity shareholders will fall, as interest on tax will be deducted from the net income. Higher the debt, higher the interest and lower the income available for equity shareholders

This in turn will reduce the ROCE, as the numerator includes the net income figure. Net income will fall and it will lead to a reduction in fall in the ROCE.

Debt being an external source of financing, whatever amount is earned, the first duty is towards the debtholders and then whatever is left after meeting their claims is left for preference shareholders and then for equity shareholders.

A decrease in amount of debt will be vice versa.

Return on asset indicate return independent of financing sources. The 2 leverage components give the effect of using creditor and preferred finance to increase the return to common shareholders.

Net incomes and PAT have a multiplying effect on the ROCE and shareholders equity divide it.

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