Assignment 1, Assigment 2

Assignment 2

Introduction

The risk in the use of different capital structure in the Company can be reduced by changing the proportion of debt and equity capital in the capital structure. The risk in using the equity capital can be offset by using the cheaper debt capital as a source of finance in capital structure.

Leverage

Leverage is the ratio of loan capital to the value of its ordinary capital. It can be calculated by using the gearing ratio that demonstrates the proportion of firm's fund used in the capital structure.i.e., the ratio of debt and equity in the capital structure.

Gearing ratio = Common stockholder’s equity/Fixed interest-bearing funds

Effect on Cost of Equity with additional leverage

Because of the use of leverage, stock volatility and return on equity improve when a company uses an appropriate degree of leverage with equity. The impact of leverage on equity capital describes the impact of debt on return on equity; this is true as long as the total return on the project exceeds the cost of additional debt. This is referred to as a positive leverage effect.

If the return on stock is lower than the interest on debt, debt capital generates less money. The Company will have to pay more for the extra capital than you will be able to make with it. This is when the negative leverage impact comes into play.

Reason for the increase or decrease in shareholders wealth.

Financial leverage will impact on the shareholders return, if the firm uses more debt finance in its capital structure means firm uses more financial leverage, this will affect the earnings of the shareholder's because the company have to pay more interest on debt capital

Impact on WACC with the use of leverage

If the capital structure of the company leverage increases WACC decreases, this is because of the tax savings by using the debt capital in the Company.

Reason for the increase or decrease in WACC.

IF the financial leverage is high then the debt equity ratio of the company will be high. The firm normally uses more debt capital in the capital structure of the Company, because debt capital is cheaper as compared to equity capital of the Company. The company can claim tax advantage on the debt capital, thereby decreases the overall cost of capital of the company.