1. If you consider the debt tax shield, all the firms should have as much debt a
ID: 2670908 • Letter: 1
Question
1. If you consider the debt tax shield, all the firms should have as much debt as they can, why then do we find that firms have not high levels of debt?2. Is it true that the debt to equity ratio has no effect in the riskiness of the stock? (hint, look at the Hamada equation)
3. What is operating leverage and why would firms use it?
4. What is financial leverage?, what is its effect on the ROE and ROIC of a firm?
5. Is it true that both financial and operating leverage increase the risk of the firm’s cash flow?
Explanation / Answer
1) high levels of debt increase debt equity ratio resulting in higher levarage, which can magnify not only potential profits but also potential losses and can have a huge impact on ROE (du pont eq) 2) D/E ratio is not a measure of riskiness (for that u might have to look at beta of the stock) 3) deg of operating leverage is (% change in EBIT)/(% change in sales) 4) deg of financial leverage is (% change in net income i.e. EPS)/(% change in EBIT)....from du pont eq ROE = net profit margin * asset turnover * leverage 5) yes as total leverage (DTL) is DTL = DOL * DFL
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