Operating or Business Risk in a Firm the Use of Debt Finance



The capital structure of a firm is made up of both debt and equity components. Although the use of debt in financing part of the firm’s operations is advantageous to the firm, these advantages tend to disappear when too much debt is used. In effect when debt is used above the optimum level, the result is financial distress. (Ross et al, 1999). Ross et al (1999) assert that debt puts pressure on the firm, since interest and principal repayments, as well as short-term payables, are financial obligations. In the event where these obligations are not met, the firm may risk some sort of financial distress. (Ross et al, 1999). Debt obligations are fundamentally different from stock obligations in that bondholders are legally entitled to interest and principal repayments more than stockholders are legally entitled to dividends. (Ross et al, 1999). In the event of bankruptcy, which is the ultimate result of financial distress, ownership of the firm’s assets is legally transferred from the stockholders to bondholders. (Ross et al, 1999). Stockholders can only claim the leftovers of liquidation proceeds after all the claims of the debt holders have been settled. (Ross et al, 1999). Although debt carries a tax advantage, the costs of financial distress tend to offset this advantage when debt is used above the optimal level. (Ross et al, 1999). The optimal level of debt can be referred to as the debt level that provides the maximum firm value. the value of the firm begins to disappear once this debt level is exceeded. (Ross et al, 1999). The firm should, therefore, adopt a debt-to-equity ratio that maximizes the value of the firm. Under this section, the required rate of return is calculated under the assumption that the risk class of the new investment remains the same as the risk of the original investment. This calculation is done before and after the issue of the new debentures. Having said this we now calculate the required rate of return before the issue of the new debentures and we later calculate the return after the issue of the new debentures. According to the traditional view, the value of a firm increases with gearing only if the firm earns more revenue than before. (Ross et al, 1999). As the company begins to shift from equity into debt, the value of the firm will be increasing provided the earnings are increasing alongside. Looking at the case for WCOA Ltd, if we assume that the earnings per share are a measure of the value of the firm, we can see that maintaining earnings constant at £72,000 without issuing more debentures yields an earnings per share (EPS) figure of £0,3569 and a return on equity of 17.85%. These results are so because when gearing is increased without a corresponding increase in earnings, the firm still suffers an interest charge on the debentures without increasing value to the shareholders as measured by the return on equity and the earnings per share. (Ross et al, 1999).