Determining the Impact of Debt on a Firm's Capital Structure Using Leverage Analysis and Net Income Approach

Abstract

The article emphasizes that the capital structure of any firm comprises two components (i.e.) Debt and Equity. The increase or decrease of the portion of stated components can significantly impact a firm's value and cost of capital. This, in turn, aids a firm in determining Optimal Capital Structure. Capital structure combines the firm's debt and equity to finance its operations and growth. Equity consists of common and preferred stocks, while debt includes loans and other borrowings. The choice of capital structure impacts a company's risk profile, cost of capital, and financial strategy. An optimal capital structure focuses on balancing debt and equity, which increases the firm's value, decreases the overall cost of capital and maintains the company's risk. A leading manufacturing firm of Puducherry has been selected for the study, and the financial data for 2018-2023 have been considered for further analysis. This study investigates the impact of debt on a firm's capital structure by employing the Leverage Analysis and Net Income (NI) Approach. By analyzing key leverage ratios, such as financial leverage, operating leverage, and combined leverage, this research aims to elucidate how varying debt levels influence a firm's economic performance and stability. The Net Income (NI) model suggests that leveraging debt can reduce the firm's overall cost of capital due to tax advantages, thereby increasing net income and shareholder value.