Exam 12: Leverage and Capital Structure

When a firm has fixed operating costs, operating leverage is present. In that case, an increase in sales results in a more-than-proportional increase in EBIT, and a decrease in sales results in a more-than-proportional decrease in EBIT.

A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and 50,000 shares of common stock. The firm's tax rate is 40 percent on ordinary income. If the EBIT is expected to be $200,000, two EBIT-EPS coordinates for the firm's existing capital structure are

Because risk premiums increase with increases in financial leverage, maximizing EPS does not assure owners' wealth maximization.

Generally, increases in leverage result in increased return and risk.

A major assumption of breakeven analysis and one which causes severe limitations in its use is that

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

An increase in fixed operating and financial cost results in an increase in risk, since the firm will have to achieve a higher level of sales just to break even.

Debt capital less risky than equity capital because the firm is legally obligated to pay interest to bondholders but they are not legally obligated to pay dividends to preferred or common stockholders.

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure.

Optimal capital structure is the capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm's value.

Business risk is the risk to the firm of being unable to cover required financial obligations.

The controversy over the existence of an optimal capital structure is debated between those ________ who believe a traditional approach exists and those ________, who do not believe one exists. In the ________ approach to capital structure, the optimal capital structure occurs where the ________ is minimized.

Business risk is the risk to the firm of being unable to cover operating costs.

A firm is analyzing two possible capital structures30 and 50 percent debt ratios. The firm has total assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of 40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30 percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of the capital structures being considered would be

The relationship between operating and financial leverage is additive rather than multiplicative.

With the existence of fixed operating costs, an increase in sales will result in ________ increase in EBIT.

The cost of debt financing results from

Operating leverage is concerned with the relationship between the firm's sales revenue and its operating expenses.

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

All items on the right-hand side of the firm's balance sheet, excluding current liabilities are called capital.