Reading 46: Measures of Leverage-LOS c 习题精选 2011, net, structure, capital, company

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Session 11: Corporate Finance
Reading 46: Measures of Leverage

LOS c: Describe the effect of financial leverage on a company's net income and return on equity.

 

 

Additional debt should be used in the firm’s capital structure if it increases:

A) firm earnings.

B) the value of the firm.

C) earnings per share.

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The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.

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Financial leverage magnifies:

A) taxes.

B) earnings per share variability.

C) operating income variability.

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Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a fixed asset base, result in a greater earnings per share variability. Operating income is based on the products and assets of the firm and not on the firm’s financing and, hence, has no impact on financial leverage. Greater financial leverage is likely to reduce taxes due to the tax deductibility of interest payments.

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Which of the following is a key determinant of operating leverage?

A) The tradeoff between fixed and variable costs.

B) The competitive nature of the business.

C) Level and cost of debt.

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Operating leverage can be defined as the trade off between variable and fixed costs.

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Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A) If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

B) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

C) Increasing financial leverage increases both risk and potential return of existing bondholders.

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If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.

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Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

Impact on Net Income

Impact on Return on Equity

A) Decrease Increase

B) No Change Increase

C) Decrease Decrease

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You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

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Which of the following firms is likely to have a higher debt ratio?

A) Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

B) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.

C) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

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Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.