Financial leverage and Capital Structure - UOL Financial Management tuition in Singapore

Financial Leverage and Capital Structure

Capital Structure is...

Proportion of debt and equity in the company used to finance the asset. Using debt to finance the assets leads to financial leverage.

What Are the Effects Of Financial Leverage?

When a company uses financial leverage, it substitutes debt for equity in the capital structure by using debt to buy back the outside equity.

Thus, it increases the available return to equity holders on their investment when the firm’s assets are able to earn a return greater than the cost of debt.

However, it also increases the risk associated with the investment. Hence, resulting in a greater range of returns available to shareholders.

Firms use debt for various reasons. As discussed by Jensen and Meckling, debt reduces outside equity and hence reduces agency cost of outside equity thus increasing the value of the firm. However, they also argued that using debt increases the agency cost of debt as managers, acting in the best interest of the shareholders choose to reject low risk high expected return project. These arguments lead to the existence of optimal capital structure, which violates MM1 proposition (http://uolfinancialmanagement.blogspot.sg/2014/02/MM1.html).

Generally, companies also use debt because it is arguable cheaper than equity.

Why Is Debt Cheaper Than Equity?

·  •Debt holders have priority over equity holders in their claims on the firm’s cash flow stream.

·       •Debt is a contractual claim

·       •Dividends are a residual claim

·       •Lenders therefore face lower risk than equity investors.

·       •Consequently, the return required by debt holders (lenders) is less than the return required by shareholders

To find out more about capital structure, SMS Val @ +65 9758-7925 or email enquiry@starcresto.com for tuition

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UOL Modules that are taught by Us:

1. Introduction to Economics

2. Principles of Banking & Finance

3. Corporate Finance

4. Financial Management

5. Principles of Accounts

6. Statistics 1

7. Statistics 2

8. Maths 1

9. Maths 2

10. Elements of Econometrics