Stock and Debt
CHAPTER 12
QUESTIONS
12-1 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage generally has no effect on EBIT—it only affects EPS, given EBIT.
12-2 Because Firm A has a higher fixed operating costs, its operating income will change by a greater percentage than Firm B’s operating income if sales change. Firm A has a higher degree of operating leverage than Firm B.
12-3 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges also will vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.
12-4 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-5 in the textbook.
12-5 Carson does have leverage because its EPS increases by a greater multiple than its sales when sales change. According to the information that is given, Carson’s DTL is 4 = 20/5. Because we have no information about either the firm’s operating fixed costs or its fixed financing costs, we cannot state whether the firm has operating leverage, financial leverage, or both.
12-6 EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage, because interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm’s future.
12-7 Expected EPS generally is measured as EPS for the coming years, and we typically do not
QUESTIONS
12-1 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage generally has no effect on EBIT—it only affects EPS, given EBIT.
12-2 Because Firm A has a higher fixed operating costs, its operating income will change by a greater percentage than Firm B’s operating income if sales change. Firm A has a higher degree of operating leverage than Firm B.
12-3 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges also will vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.
12-4 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-5 in the textbook.
12-5 Carson does have leverage because its EPS increases by a greater multiple than its sales when sales change. According to the information that is given, Carson’s DTL is 4 = 20/5. Because we have no information about either the firm’s operating fixed costs or its fixed financing costs, we cannot state whether the firm has operating leverage, financial leverage, or both.
12-6 EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage, because interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm’s future.
12-7 Expected EPS generally is measured as EPS for the coming years, and we typically do not
References: The following articles might be assigned for background material: Emily Thornton, “Gluttons at the Gate,” BusinessWeek, October 30, 2006, pp David Henry, “Cross-Dressing Securities,” BusinessWeek, March 13, 2006, pp. 58-59.