1. An increase in a firm\'s financial leverage will: A. increase the variability
ID: 2754635 • Letter: 1
Question
1.
An increase in a firm's financial leverage will:
A. increase the variability in earnings per share.
B. always reduce the operating risk of the firm.
C. increase the value of the firm in a non-MM world.
D. increase the WACC.
2.
Assume a firm is financed with 30% debt on which it pays 9%. What is the expected return on equity if the expected return on assets is 14%?
3.
The trade-off theory of capital structure describes the optimal capital structure for any firm as being the level of debt that:
A. minimizes the financial distress costs.
B. maximizes the present value of the interest tax shield.
C. equates the present values of the interest tax shield and the financial distress costs.
D. maximizes the after-tax cash flows that are internally generated.
Explanation / Answer
1)
A. increase the variability in earnings per share.
Increasing the financial leverage would mean increasing the debt of the company that would change the interest expenses depending on the terms of debts and its repayments, which is result in fluctuation in net income hence a variablility in Earning per share.
2)
3)
C. equates the present values of the interest tax shield and the financial distress costs.
Trade-off theory of capital structure primarily deals with the two concepts – cost of financial distress and agency costs. An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity.The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal.
Net income 1400 (assumed) expected return on asset 14% Total asset 10,000 Debt financing -30% 3,000.0 (10000*30%) Equity portion -60% 6,000 (10000*60%) Return on Equity 23.3% 1400/6000*100Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.