Answer to Question #50537 in Microeconomics for Rekha

Question

If the use of financial leverage magnifies the earnings per share under favorable
economic conditions, why do companies not employ very large amount of debt
in their capital structures? Justify your views in elaborate. Detailed answer i need mark of this question 15 marks

Answer 1

Recall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.
With an increased debt load the following occurs: Interest expense rises and cash flow needs to cover the interest expense also rise.Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.
Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all.
In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.