The debt brings with it future cash flow commitment in the form principle borrowed and periodic interest which increases the potential risk of firms default and bankruptcy. (Ebaid, 2009). Modgliani and Miller in their analysis had proved that firm can lower their cost of capital by increment of leverage in their capital structure. However considerable use of debt financing would expose business to high probabilities of default (Khan and Jain, 2005).Not only this, the firms will also find it demanding to meet the promised principles and interest. Furthermore, the firm is likely to incur costs and suffer penalties if it is not able to pay the interest and principles on time. This may result in legal outlays, interruptions in…show more content… Also the net operating incomes for the three scenarios are £5 m, £20 m and £35 m respectively. The different cases for gearing are as follows:
Case 1: Debt (100%) and Equity (0%)
Case 2: Debt (25%) and Equity (75%)
Case 3: Debt (50%) and Equity (50%)
(Pike, Neale and Linsley, 2006, p.487)
It is crucial to recognize that, 300% increase in net operating income (NOI) in case 1 leads to 600% increase in shareholder earnings. Unfortunately, it also has a downside where the decrease in NOI will cause a significant drop in share holder’s earnings almost double than what NOI experiences. In scenario A under case 3, it is interesting to observe that shareholder earnings have been wiped out even before the interest is charged. This makes it evident that any further increase in gearing will give rise to negative return on equity. Thus this point can be inferred as the point for optimal capital structure. Thus the Lindley PLC case demonstrates that, under debt financing, even though it provides superior returns in good years, they stand to receive even worse returns in bad years (Pike, Neale and Linsley, 2006).
The diagram below sums up the gearing effect on % return on equity. (Pike, Neale and Linsley, 2006, p.488)
The other factor that results from debt financing is the agency cost. When the firm has debt, conflicts of interest arise between stockholders and