Question

If the use of financial leverage magnifies the earnings per share under favourable economic conditions, why do companies not employ very large amounts of debt in their capital structures?

Answer 1

If the use of financial leverage magnifies the earnings per share under favourable economic conditions, why do companies not employ very large amounts of debt in their capital structures?

Answer 2

The use of financial leverage magnifies shareholders return on the assumption that the debt funding can be had a cost lower than the firms rate of return on net assets.

Explanation:

• The above reason companies do not employ very large amount of debt in their capital structure despite the advantage of financial leverage.
• The numerator of the financial leverage figure increases, so the overall financial leverage number rises, it is boosting ROE.
• ROE means Return on equity.
• The financial leverage ratio is 0.5 or less, it is ideal.
• In other words the financial leverage ratio indicates, a debt ratio of 0.5 will necessarily mean a debt-to-equity ratio of 1.
• In both cases, a lower number indicates a company is less dependent on borrowing for its operations.

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