Suppose there are two firms with the same assets but different capital structure

Question

Suppose there are two firms with the same assets but different capital structures. Firm U uses no debt, while Firm L uses $100 debt, or 50% debt ratio. (See the blue-colored section of the balance sheets).

Balance Sheet

Firm U (Unlevered)

Firm L (Levered)

The following income statements are based on the assumption that these two firms are exactly the same in terms of their businesses; the same revenues ($100) and operating costs ($50). However, since Firm L uses debt ($10, rd=10%) while Firm U does not, total income available to the capital contributors (= investors) are different for these two firms; $60 for Firm U and $64 for Firm L. More is available to the investors of Firm L than firm U.

Income Statement

Firm U (Unlevered)

Firm L (Levered)

The above income statements show that extra $4 is available to the investors of Firm L compared to Firm U. Where does this extra $4 ( = 64 - 60) come from? The extra $4 is the tax savings. Interest payment of $10 creates the $4 tax savings for the firm. The calculation is as follows:

The firm has $100 debt.
==> The firm pays $10 (=10% of $100) interest.
==> The firm's taxable income is reduced by $10, the same as the interest payment.
==> The firm's tax liabilities are reduced by $4 (=40% of $10).

Therefore, the annual tax savings can be found by the following formula:
D x rd x T, where D = debt, rd = interest rate and T = tax rate.

For example, if a company borrows $10 million at the interest rate of 10% and the firm pays 40% tax, the annual tax savings would be $400,000 = $10m x (0.1) x (0.4).


3.4.2. Financial Risk versus Business Risk

Let's now calculate the rate of return to stockholders for these two firms.

Firm U(Unlevered)

Firm L(Levered)

Return on Equity (ROE)

$60 / $200 = 30%

$54 / $100 = 54%

Firm U (Unlevered)

Firm L (Levered)

Current Assets $100 $100 Fixed Assets 100 100 Total Assets 200 200 Debt (rd = 10% ) $ 0 $100 Common Stock 200 100 Total Liab and Equity 200 200

Explanation / Answer

Yes, I think 54% return to the shareholders of Levered firm is better than the 30% of return to the shareholders of unlevered firm,here are the reasons for the above statement.

So, we conclude that presence of debt helps to increase earnings of owners if there are higher earnings else it would be a risk in case of lower earnings or negative earnings as it is fixed payment this has been explained in point 3.

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