Financial Leverage and Capital Structure Policy
CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
Answers to Concepts Review and Critical Thinking Questions
1. Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage.
2. No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.
3. Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it’s practically impossible to determine the precise debt-equity ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more expensive, it’s probably true that the firm is too highly leveraged.
4. The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter.
5. It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
6. Homemade
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY
Answers to Concepts Review and Critical Thinking Questions
1. Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage.
2. No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise.
3. Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it’s practically impossible to determine the precise debt-equity ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more expensive, it’s probably true that the firm is too highly leveraged.
4. The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter.
5. It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
6. Homemade