5.14 Review Questions: Chapter Five
Review Questions: Chapter Five
- What effect does Financial Leverage have on Net Income, Earnings per Share, and Return on Equity? Explain.
- Financial Leverage modifies the relationships between _____ and _____.
- When observing the slope of the EBIT/ROE (or the EBIT/EPS) line, a steeper slope represents lesser / greater leverage. (Remember: EBIT is on the horizontal axis.) Which is it? Why?
- Under what circumstance is leverage advised or ill-advised?
- Calculate the Crossover Point, given the following:
-
- Total Capital $2.5 million
- 100,000 shares outstanding, assuming no debt
- YTM = 5%
- Tax Bracket = 35%
- Interest Rate = 6%
- There is no preferred stock
- In the prior question, state not just the EBIT, but its consequent levels of ROE and EPS.
- This text solves the question of the Crossover Point by reference to ROE. Present the parallel formula using EPS.
- If debt is cheapest, why not use it to the max?
- List and discuss the merits and demerits of using debt in a firm’s capital structure.
- How does debt interact with Operating Risk, if at all? Explain.
- A guiding principle in determining the optimal level of debt has to do with minimizing the firm’s Weighted Average Cost of Capital. Explain.
- Another guiding principle has to do with maximizing the firm’s value. Explain.
- What four variables are relevant in determining the firm’s actual degree of leverage? Explain.
- What is meant by External Funds Needed?
- What are Internal and External Funds?
- Why is the notion of External Funds Needed so very important?
Selected Answers
Question 5:
It does not matter what amount of leverage you assume; the crossover point will be the same for all amounts of leverage. Let us assume 50%. Why not?
(EBIT) (.65) / 2,500 = (EBIT- 75) (.65) / 1,250
EBIT = 150
Question 6:
ROE = (150) (0.65) / 2,500 = 0.039
EPS = (150) (0.65) / 100 = $0.975