FIN 200 Week 4 DQ 2 - 7547

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Limitations of Financial Leverage:

 

a) Cost of debt is lower than cost of equity. Leverage provides tax shield as interest expenses is charged as expenses in income statement. But, beyond a point, debt financing is detrimental to the firm. More debt means company will face problem in honoring debt. Company's long term solvency may become questionable. So, after a limit, any increase in financial leverage results in higher cost of debt and so higher cost of capital.

b)Lenders will perceive a greater financial risk associated with the company if company has very high financial leverage.

c)High leverage means more solvency risk. This is reflected in fall of share price.

 

High financial leverage means poor leverage ratios (high debt-to equity ratio, low interest coverage ratio etc). It indicates poor financial health of the company.

Solution Description

Limitations of Financial Leverage: