Given the possibility to boost return on equity substantially, why is it that every publicly traded corporation doesn’t make extensive use of financial leverage?
–as I mentioned in my initial post, in some areas of the world investors think using debt capital is a bad thing, either because they believe debt is unethical or (incorrectly, in my American view) that debt is more expensive than equity
Philosophy aside, having debt on the balance sheet has risks:
–debt service (interest and principal repayments) is an immediate subtraction from operating cash flow. If a company takes on excessive debt, if it makes a mistake in capital deployment, or if it is particularly sensitive to the ups and downs of the business cycle, debt service can become a burden. In extreme cases, debt holders may have the right to accelerate the repayment schedule, restrict company operations–or even take over management of the firm through bankruptcy proceedings
–having a large amount of debt can hamper a firm’s ability to respond to a changing competitive environment. Macy’s failure to build an effective online retail presence, for instance, has been attributed to its need to devote large amounts of operating cash flow to debt service.
In addition, Wall Street investors tend to believe (correctly, I think) that it doesn’t take much skill to float a bond issue or get a bank loan. It’s much harder to employ capital well in running operations. So while investors may want the extra returns that a leveraged company can achieve, they will pay a much higher price for returns on capital than for returns on leverage.