Problem: In a world with corporate taxes, what happens when the firm adds debt to its capital structure?
Lucky Bamboo is a fast growing firm. It grows bamboo which it uses to manufacture bamboo furniture, blinds, fences, and flooring. Its latest project is Lucky Bamboo Sticks, which it sells to grocery stores such as Whole Foods and Central Market. Lucky's products have taken off since they were featured in various magazines and television shows. Lucky is considering changing its capital structure from zero debt to 50% debt. Will this change in capital structure be beneficial to Lucky Bamboo's shareholders?
Financial Concept: Financial leverage is the extent to which a firm is financed by securities with fixed costs, such as debt and preferred stock. The advantage of corporate debt is that it is a deductable expense, while equity income is taxable. Financial leverage increases the expected rate of return to shareholders.