Assessing the Effect of Debt/Equity Ratio on Firm's Market Value

This report analyzes the impact of a firm's debt-to-equity ratio on its market value. The debt-to-equity ratio, a key financial leverage metric, is explored in detail, highlighting its influence on a company's financial stability. The report explains that an increase in the debt-to-equity ratio can signal higher risk but also potentially higher returns for shareholders if the company generates earnings exceeding the cost of debt. The report also touches upon the importance of capital structure decisions made by financial managers to optimize firm value. Tax benefits related to interest payments, and the use of debt as an indicator of future performance are also discussed, with a conclusion that an increase in the debt-to-equity ratio can positively impact the market value of the company in the long run if larger returns are generated, benefiting shareholders and stakeholders. The report references several academic sources to support its analysis.

Effect on the firm’s market value of an
increase in the firm’s debt to equity ratio

TABLE OF CONTENTS
Impact of D/E ratio on market value of firm...............................................................................1
REFERENCES................................................................................................................................3

Impact of D/E ratio on market value of firm
Debt equity ratio referred as the leverage ratio that evaluates financial stability of an
enterprise in the long run by making use of the data present in the balance sheet (Gamayuni,
2015). Increase in the D/E ratio shows reflects high risk on the company as it means that the firm
seems to be very aggressive in terms of financing its growth through the use of its debts or long
term borrowings.
Debt equity ratio measures the debt of an entity to its net assets and is often used for
gauging an extent Up-to which an organisation is taking the debts for the purpose of leveraging
their assets. In case more of the debt is utilised for financing the growth, company could generate
higher earnings than the company would have without the financing (Dhankar, 2019). If in a
situation the leverage increases the level of earnings with a greater value than debt's cost, the
shareholders are expected to benefit with higher returns. On the other hand, if the debt financing
cost outweighs an increase in the income generated, value of the shares might decline. Debt cost
could vary with the market situations or the circumstances and thus, unprofitable borrowings
might not seen as apparent.
An organization has two options in financing their activities that is by issuance of the
debts or an equity, however, the most preferred one is the mix of both debt and equity financing
(Yapa Abeywardhana, 2017). Making decisions on the level of equity and debt counted as the
crucial role that is been played by the financial managers, who seeks for selecting optimal level
of capital structure that is the one which helps in maximizing firm's value and in minimizing the
capital cost. Tax deduction in respect of interest payments had made an entity for relying on the
debts against an equity and thereby causing increase in the equity and the debt ratios which in
turn increases in the bankruptcy risk and also leads to rise of the debt bias.
The use of the debts within the capital structure of an entity facilitates an information
about the future performance (Rehman, 2016). The firm could be able to reap for higher profits
with maintaining higher debt-to-equity ratio by making use of more and more debts in
comparison to the equity.
Thus, rise in the debt equity ratio highly impacts the market value of the company as in
the long run if larger returns are been generated then it indicates a positive sign for the
shareholders and the stakeholders in getting higher dividends and profits with an increase in the
market value of the company in the future periods (Tahmoorespour, Mina and Randjbaran,
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2015). However, in case if the funds invested in the assets and equities results in losses then it
could be seen as higher risk for the firm with regards to insolvency and high amount of the
financial burden.
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REFERENCES
Books and Journals
Dhankar, R. S., 2019. Cost of Capital, Capital Structure, Dividend Policy and Value of Firm.
In Capital Markets and Investment Decision Making (pp. 187-196). Springer, New Delhi.
Gamayuni, R. R., 2015. The effect of intangible asset, financial performance and financial
policies on the firm value. International journal of scientific & technology research. 4(1).
pp.202-212.
Rehman, O. U., 2016. Impact of Capital Structure and Dividend Policy on Firm Value. Journal
for Studies in Management and Planning. 2(2). pp.308-324.
Tahmoorespour, R., Mina, A. and Randjbaran, E., 2015. The impact of capital structure on stock
returns: International evidence. Hyperion Economic Journal. 1(3). pp.56-78.
Yapa Abeywardhana, D., 2017. Capital structure theory: An overview. Accounting and finance
research. 6(1).
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