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Debt to Equity Proportions

Debt to Equity Proportions

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Published by ClassOf1.com
In building the pool of funds for the business it is important to balance and optimize the proportions of debt and equity. The relationship between total debt and total equity is referred to as leverage or gearing.
In building the pool of funds for the business it is important to balance and optimize the proportions of debt and equity. The relationship between total debt and total equity is referred to as leverage or gearing.

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Published by: ClassOf1.com on Jul 03, 2013
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07/03/2013

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BusinessManagement 
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Sub: Business Management Topic:
 
WACC
*
Debt to Equity Proportions
In building the pool of funds for the business it is important to balance and optimize the proportionsof debt and equity. The relationship between total debt and total equity is referred to as leverage orgearing. If there is too much debt, a business becomes highly leveraged with the implications of:Repayment risk. The risk to debt providers increases as there is less of an equity buffer toabsorb losses that the business may make.Interest risk. The interest cost must be met before dividends can be paid to shareholders. If interest cannot be paid and there is a serious risk of the business not being able to repay thedebt, funders will exercise rights in their loan agreements to force repayment from assetsales.Cost. With enhanced risk to debt providers the cost of the loans is likely to rise in the form of increased interest rates. If there is too little debt, shareholders lose out through dilution of earnings which limits their return by:Greater weighted average cost of capital (wacc). As equity is more expensive than debt, thebusiness can lower its wacc by replacing equity with cheaper debt; the enhanced earnings canthen be passed back to shareholders.Restrained growth. With too little borrowing the business may be operating sub-optimally asit could borrow more to fund expansion and achieve greater growth.To prevent businesses from borrowing too much there are often covenants in a loan agreement thatconstrain the business. A common covenant is that a loan becomes immediately repayable if acertain debt to equity ratio is exceeded. The optimum leverage for a business is seen to be around50% of total funds. At this level the interest rate on debt is optimized and the return on equity ismaximized. There can be scenarios where a higher level of leverage can be tolerated without the
 
 
Sub: Business Management Topic:
 
WACC
*
interest rate rising. This might be for businesses that have significant infrastructure which has apotential tradable value, such as the assets in property businesses or hotels where the quality of theassets will enable them to take on greater debt. Assets in the form of specialist machinery are lesstradable and therefore provide lower-quality security. There are many methods of calculatingleverage and debt to equity ratios. Options are whether to include or exclude items such as payables,pension deficits and other liabilities. One of the best methods is to compare interest-bearing debt toequity. This focuses on pure funding and excludes the operational aspects of the business such aspayables. The higher the ratio the more highly leveraged is the business, and the closer the attentionthe lending banks will pay to its ability to cover its interest payments, and the more control they willexercise over the business.

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