effect of increased debt

Just wanted some discussion on this… If the company takes more debt (and so the debt ratio goes up) what will be the effect on ROE and Net profit margin(Assuming that sales,Assets and OP.Income are not changed) A)ROE will go down B) net profit margin will go down IMO, It is B because, higher debt will result in higher Interest and so NI will go down which will take Net P.Margin down(since sales are unchanged) Although the numerator of A goes down , its denominator also goes down (For same assets, higher debt will reduce the equity) and therefore only B goes down.

actually I believe it will be both a and b. NI goes down. Equity also goes down. But NI goes down MORE. So ROE will go down, as a result.

I think if we have to select between the two it has to be NPM right? Not sure about ROE because there could be some cases it will not necessarily be true.To be able to select an option it has to be true in all the cases.

I don’t like your assumption. the reason a company takes more debt is to invest in equipment, grow and increase sales, etc …

DUPONT EQUATION: ROA = Net profit margin * asset turnover* Leverage. so , It depends on how much debt the company has and by how much net profit margin decrease. So you can not tell that ROA will go down unless you have enough information, but you can say net profit margin will go down becuase of higher interest rates.

I think he means ROE not ROA

YUP, sorry

maratikus Wrote: ------------------------------------------------------- > I don’t like your assumption. the reason a > company takes more debt is to invest in equipment, > grow and increase sales, etc … Good point here! we would actually need more info though, such as: How much will the sales go up? There is also no doubt that assets will increase, unless the company decided to reduce equity to keep the same D/E ratio…which wouldn’t make much sense.

This effect is known as financial leverage .When ROE is high, financial leverage makes it even higher and vice versa. In Debt financing, In the early years, NI and ROE go down because of higher interest paid but reverse is true in the later years because of more sales and lower Interest payments due to amortization effect. ROE= ROAxFL Debt financing better choice when company does not want to liquidate the EPS by issuing more shares to finance its operations etc.