Final Answer:
The suggestion to increase leverage with a Debt-to-Value (D/V) ratio of 0.75 and Equity-to-Value (E/V) ratio of 0.25, leading to a higher ROE, could be advantageous if the cost of debt is lower than the return on equity. However, the potential risks associated with increased leverage, such as higher financial distress and interest rate fluctuations, should be carefully considered before implementing this strategy.
Step-by-step explanation:
Increasing leverage can amplify returns on equity, as the cost of debt is typically lower than the return on equity. The return on equity (ROE) is calculated using the DuPont formula: ROE = Net Profit Margin (Net Income/Revenue) × Asset Turnover (Revenue/Assets) × Equity Multiplier (Assets Equity). In this case, if the interest expense is $2 million and operating earnings remain unaffected, the increase in leverage would lead to a higher Equity Multiplier, thus boosting ROE. However, the potential downside involves increased financial risk. Higher leverage implies a greater obligation to service debt, and if operating conditions worsen, it may lead to financial distress.
Furthermore, the firm needs to consider interest rate fluctuations. If interest rates rise, the cost of debt increases, impacting profitability. Conversely, if interest rates decline, the firm benefits from lower interest expenses. Careful consideration of the business's risk tolerance, market conditions, and the stability of cash flows is crucial. While higher leverage can enhance returns, it also exposes the company to increased financial volatility. Striking a balance between optimizing ROE and maintaining financial stability is key to making an informed decision on capital structure adjustments.