Effect of financial leverage

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The Effect of Financial Leverage

Biddle publishing currently is financed with 10% debt and 90% equity.  However, Biddle's CFO has proposed that the firm issue new long-term debt and repurchase some of the firm's common stock.  Biddle's advisors believe the long-term debt would require a before-tax yield of 10%, while the firm's basic earning power (BEP) is 14%.  The firm's operating income and total assets will not be affected.  The CFO has told the rest of the management team that he believes this move will increase the firm's stock price.  If Biddle proceeds with the recapitalization, which of the following items is also likely to increase-

-       Cost of Debt

-       Net Income

-       Return on Assets

-       Cost of Equity

-       Basic Earning Power


The CFO's proposal has opened up a dialogue among the company's management team about the effects of debt financing.  In particular, one manager notes that debt financing is cheaper than equity financing.  He suggests that using more debt always will decrease the firm's weighted average cost of capital.  Is this true-

-       No

-       Yes


Optimal Capital Structure

Rosewood Fabrics and Taggart Security Systems are two firms trying to identify their optimal  capital structure.  Rosewood's CFO has gathered the following financial information to help with the analysis.

Debt Ratio

Equity Ratio



Stock Price


























What capital structure described above is Rosewood's optimal capital structure-

-       Debt Ratio = 70% equity ratio = 30%

-       Debt Ratio = 40% equity ratio = 60%

-       Debt Ratio = 50% equity ratio = 50%

-       Debt Ratio = 60% equity ratio = 40%

-       Debt Ratio = 30% equity ratio = 70%


Taggart's CFO also has collected financial information regarding the firm's capital structure, show in the following table. 


Debt Ratio

Equity Ratio






























Which capital structure described above is Taggart's optimal capital structure-

-       Debt ratio = 50% equity ratio = 50%

-       Debt ratio = 70% equity ratio = 30%

-       Debt ratio = 40% equity ratio = 60%

-       Debt ratio = 30% equity ratio = 70%

-       Debt ratio = 60% equity ratio = 40%


Would an increase in the corporate tax rate tend to encourage firms to increase or decrease their debt ratio-

-       Decrease

-       Increase


Leverage effects on beta

Maitland INC currently has a capital structure consisting of 30% debt and 70% equity.  However, Maitland's CFO has suggested that the firm's increase its debt ratio to 50%.  The current risk-free rate is 6% and the market risk premium is 5%, while Maitland's beta is 1.30.  If the firm's tax rate is 40%, what would the beta of an all -equity firm be if its operations were exactly the dame-

-       1.2500

-       1.2174

-       0.9583

-       1.1534

-       1.0341


If Maitland raised its debt ratio to 50% how much would its cost of equity change-

-       2.05%

-       2.00%

-       1.77%

-       2.50%

-       1.98%


Which of the following statement is correct-

-       If the company has no debt outstanding then its degree of total leverage equals its degree of financial leverage

-       An increase in fixed costs (holding sale and variable costs constant) will reduce the company's degree of operating leverage

-       If a firm's degree of operating leverage increases, its degree of financial leverage must also have increase

-       If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage

-       An increase in interest expense will reduce the company's degree of financial leverage


The use of financial leverage by the firm has potential impact on which of the following-

(1) The risk associated with the firm

(2) The return experienced by the shareholder

(3) the variability of net income

(4) the degree of operating leverage

(5) The degree of financial leverage

-       1,2,3,5

-       2,3,4,5

-       1,3,5

-       2,3,5

-       1,2,5


Which of the following statements is correct-

-       If a firm's after tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt

-       There is no reason to think that changes in the personal tax rate would affect firms capital structure decisions

-       In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs

-       Suppose a firm has less than its optimal amount of debt.  Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity

-       A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal



Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk.  Company HD, however has a higher debt ratio than LD.  Company HD's basic earning power ratio (BEP) exceeds its cost of debt(rd) which of the following statements is correct-

-       Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's

-       The two companies have the same ROE

-       Company HD has a higher return on assets (ROA) than Company LD

-       Company HD's ROE would be higher if it had no debt

-       Company HD has a higher times interest earned (TIE) ratio than Company LD


Which of the following statements is correct-

-       When a company increases its debt ratio, the costs of equity and debt both increase.  Therefore, the WACC must also increase

-       Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC

-       All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios

-       The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share

-       Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income


Cash Conversion Cycle (CCC)

Kahane Co. has an inventory conversion period of 48.00 days, an average collection period (ACP) of 42.75 days, and a payable deferral period of 26.25 days.  What is Kahane's cash conversion cycle-

-       65.00 days

-       64.50 days

-       65.25 days

-       65.50 days

-       64.75 days


A review of Kahane's balance sheet indicated that it has accounts receivable fo $77,134.00 If Kahane's COGS is 80% of annual sales, what is the firm's inventory turnover-

-       9.51x

-       9.66x

-       9.36x

-       8.82x

-       8.69x



Suppose a firm wants to take advantage of an upward slopping yield curve.  If the firm believes that interest rates will stay constant and wants to use the current yield curve to bolster profits, which approach should the firm follow-

-       Conservative approach

-       Maturity matching approach

-       Aggressive approach


Suppose a firm occasionally faces demand for short-term credit but usually has an excess of short-term capital to finance current assets.  Which approach is the firm following-

-       Conservative approach

-       Maturity matching approach

-       Aggressive approach


Which usually costs less-

-       Long-Term Debt

-       Short-Term Debt


Which is usually riskier to the borrowing firm if it is most concerned with rising interest rates

-       Long-Term Debt

-       Short-Term Debt

Cost of Trade Credit

Standish incorporated buys on terms of 1/5, net 40 from its chief supplier.  What is the nominal annual cost of the trade credit that supplier extends-

-       36.87%

-       49.66%

-       24.83%

-       10.53%

-       74.49%

Suppose Standish doesn't take the discount and chooses to pay its supplier late.  On average, Standish pays its supplier on the 50th day after the sale.  By how much does Standish decrease its actual nominal cost of trade credit by paying late-

-       2.34%

-       12.29%

-       3.68%

-       6.15%

-       12.41

What is the effective annual cost of trade credit for Standish if it continues paying on the 50th day after the sale-

-       11.05%

-       8.49%

-       20.13%

-       27.86%

-       34.31%

Choosing short-term financing

Civella Industries is considering a few different options for financing its working capital.  Its main supplier offers credit terms of 1/10 net 45.  Alternatively, Civella could take out a one-year simple interest bank loan for $100,000 with an interest rate of 12.9%.  The simple interest loan requires interest to be paid monthly.  As another option, the bank has offered a one-year, 7.5% add-on interest loan for $100,000.  The add-on interest requires equal monthly payments.  Calculate the effective rate cost of each financing alternative and complete the table below-



Trade Credit

-       11.05%

-       7.61%

-       24.90%

-       17.81%

-       23.45%

Simple Interest Loan

-       15.73%

-       13.35%

-       14.37%

-       15.05%

-       13.69%

Add-on Interest

-       14.04%

-       14.24%

-       14.44%

-       14.64%

-       13.84%

Based solely on their effective costs, which financing option should Civella Chose

-       Add-on interest bank loan

-       Simple interest bank loan

-       Use supplier trade credit

Reference no: EM13715


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