Exam 13: Leverage and Capital Structure

At the operating breakeven point, the sales revenue is equal to the sum of the fixed and variable operating costs.

Generally, the greater a firm's times interest earned ratio, the less able it is to meet payments as they come due.

Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40 percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and dividends are expected to grow at a constant rate of 5 percent for the foreseeable future. Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share. Because of the additional leverage, dividend growth is expected to increase to 6 percent and this growth will be sustained indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 11.34 percent. (a) What is the value per share for Tangshan Mining under the current capital structure? (b) What is the value per share for Tangshan Mining under the proposed capital structure? (c) Should Tangshan Mining make the capital structure change? Explain.

As financial leverage increases, the cost of debt initially remains constant and then rises, while the cost of equity always rises.

In theory, a firm's optimal capital structure is that which minimized the firm's overall cost of capital resulting in a maximization of the market value of a firm.

A firm's ________ is the mix of long-term debt and equity utilized by the firm, which may significantly affect its value by affecting return and risk.

In general, the greater a firm's operating leverage, the higher its business risk.

Because the degree of total leverage is multiplicative and not additive, when a firm has very high operating leverage it can moderate its total risk by ________.

Earnings before interest and taxes (EBIT) is a descriptive label for ________.

________ leverage measures the effect of fixed ________ costs on the relationship between EBIT and EPS.

The relative inexpensiveness of debt capital is due to the fact that the lenders take the least risk among the long-term contributors of capital.

________ analysis is a technique used to assess the returns associated with various cost structures and levels of sales.

The total leverage measures the combined effect of operating and financial leverage on a firm's risk.

Generally, decreases in leverage result in increased return and risk, whereas increases in leverage result in decreased return and risk.

________ leverage is concerned with the relationship between sales revenue and earnings per share.

A decrease in fixed financial costs will result in a(n)________.

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes earnings before interest and taxes (EBIT) over the expected range of earnings per share (EPS).

A decrease in fixed operating costs will result in ________ in the degree of financial leverage.

Leverage results from the use of equity to magnify returns to a firm's owners.