Question

The new financial policy primarily involves taking on more debt to repurchase shares and should not have any major effects on the investment policy of the firm. Increasing leverage to repurchase shares will likely have benefits as well as costs. Based on the information provided in the case, briefly discuss two potential benefits and two potential costs associated with this transaction?

Answer 1

Increasing leverage to repurchase shares can lead to an increase in shareholder value and signal confidence to investors, but also carries the risk of higher financial obligations and reduced flexibility due to increased debt.

Step-by-step explanation:

The financial policy in question involves the firm increasing its leverage by taking on more debt to repurchase its shares. There are potential benefits and costs to this strategy.

Potential Benefits:

1. Increase in Shareholder Value: By repurchasing shares, the firm reduces the number of shares outstanding, which could potentially increase the earnings per share (EPS) and, as a result, the share price, benefiting existing shareholders.
2. Signal of Confidence: A repurchase can be seen as a signal that the firm's management believes the shares are undervalued, which could positively influence investor perception and boost the company's stock price.

Potential Costs:

1. Increased Financial Risk: Taking on more debt increases the firm’s leverage and its interest obligations, which could be a burden if the company's profits do not meet expectations.
2. Reduced Financial Flexibility: The firm might have less cash available for other opportunities or may find it more difficult to obtain financing in the future due to a higher debt load.