\tAll trial balances and income statements include a plethora of accounts. Irrefragably, all these accounts seem to be important; nonetheless, Debt and Equity possess special characteristics. To understand their importance, recall the U.S. banking crises during 2008. Their stock values reached a zenith, but finally, a noticeable number of banking institutions failed and were insolvent. This happened because the U.S. banking institutions did not have enough equity to minimize or remove financial complexities. To perorate, equity and debt determine the financial strength and riskiness of every entity. Hence, every entity should determine, if it supports profit maximization or risk minimization.
\nThe Debt?s Effect on Earnings per Share (EPS) and Return on Equity (ROE)
\nIt is assumed that the use of debt improves the firm?s financial performance ratios, such as, Earnings per Share (EPS) and Return on Equity (ROE). It is also known that:
\nNet earnings = Earnings before Interest and Taxes (EBIT) ? Interest Expenses ? Taxes.
\nFurther, it is indicated that the basic equation of any firm?s financial condition subjects itself to the here below stated formula, named as Basic Equation:
\nAssets = Liabilities (Debt) + (Equity +Net Earnings) (Mao, 1969; Solomon & Pringle, 1977).
\nNotably, net earnings represent an entity?s, year to-date, profits or losses (Porter & Norton, 2008). Additionally, the ratio of Equity over Total Assets is known as Financial LeverageRatio (Mao, 1969; Solomon & Pringle, 1977; Van Horne & Wachowicz, 2008).
\nTo better understand the interrelationship among Equity, Debt, EBIT, Interest Expenses, Tax Rate, EPS, and ROE, the Table 1 presents a numeric example of company A. The financial data for the company A have as follows: (a) the assets have a value of $1,000, (b) the earnings before interest and taxes (EBIT) are equal to $250, (c) the tax rate is 50%, (d) the interest rate is 15%, (e) the stock price is $20 per share, and (f) there are 5,000 ($100,000 \/ $20) outstanding shares.
\nThe columns 1, 2, and 3 in the Table 1 present various results according to three different conditions: (a) the column 1, shows the firm has a $1,000 equity and $0 debt; (b) the column 2, shows the firm has a $600 equity and a $400 debt; and (c) the column 3, shows the firm has a $400 equity and a $600 debt.
\nTable 1
\n\t The Interrelationship among Equity, Debt, EBIT, EPS, ROE, Interest, and Taxes
\n\tEquity 100% = $1,000
\nDebts = $0\tEquity 60% = $600
\nDebt = $400\tEquity 40% = $400
\nDebt = $600
\nElements\t(1)\t(2)\t(3)
\nAssets\t$1,000\t$1,000\t$1,000<\/p>\n
Equity\t$1,000\t$600\t$400
\nDebt\t0\t$400\t$600<\/p>\n
EBIT\t$250\t$250\t$250
\nInterest 15%\t0\t$60\t$90
\nGross Income\t$250\t$90\t$160<\/p>\n
Tax 50%\t$125\t$95\t$80<\/p>\n
Net Income\t$125\t$95\t$80<\/p>\n
Equity\t$1,000\t$600\t$400
\nNo. of Shares\t50\t30\t20<\/p>\n
EPS\t$2.50\t$3.167\t$4.00
\nROE\t12.50%\t15.83%\t20.00%<\/p>\n
1.\tPlease, state your thoughts in reference to the use and effect of debt.
\n2.\tShould a firm utilize debt or not?
\n3.\tIf your answer is yes, what do you thing the maximum level of debt should be? And
\n4.\tIf your answer is no, why do you support this assumption?<\/p>\n
<\/p>\n","protected":false},"excerpt":{"rendered":"
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