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In this chapter, we talk about debt and its often unfortunate consequence, bankruptcy. The judicious use of debt can make a company more profitable and give greater return to shareholders. Over use of leverage (debt=leverage) can lead to disaster and the breakup of the firm.
First, let's examine why it is called leverage. Just as a lever can allow you to lift a greater weight than you could straight on, thereby multiplying your strength, the use of debt can allow a company to do more than it could with just its own capital alone. But leverage works both ways -- just as it can multiply return when properly used, it can multiply losses when things don't go as planned.
When you finish this chapter,
you should understand more fully the effects of leverage,
you should know the effects of bankruptcy and taxes on capital structure choice, and
you should understand the basics of the bankruptcy process.
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