1) When comparing levered versus unlevered capital structures, why does leverage
ID: 2754657 • Letter: 1
Question
1) When comparing levered versus unlevered capital structures, why does leverage work to increase EPS for very high levels of earnings before interest and tax (EBIT)?
Because interest payments on debt vary with EBIT levels such that low EBIT leads to the lowest interest payments.
Because interest payments on the debt stay fixed, leaving the remaining income to be distributed among less shares of stock
Because risk units of debt are likely to be lower than risk units assigned to equity
Because other things equal, more taxes are paid under the levered capital structure than under an unlevered capital structure
Because interest payments on debt can be put off until some date in the future such as the date of debt maturity
2) Sinclair, Inc. is a levered firm with assets valued at $10,000 and has debt issued at 10% interest. Sinclair pays tax at the rate of 34%. The firm faces EBIT scenarios of recession and boom. {Note: EBIT = earnings before interest and tax, $ Interest = dollar amount of interest owed on the debt, NIBT = net income before tax, NI = net income, EPS = earnings per share}. Assume that firms with zero or negative NIBT pay zero taxes.
What amount comes closest to Sinclair’s EPS in the RECESSION scenario?
- $7.33
$7.33
$10.00
- $10.00
$0
3) Why do firms with leverage, all else equal, pay less tax than forms without leverage?
Because of homemade leverage.
Because risk units are higher with levered firms.
Because firms with negative net income don’t owe any taxes.
Because interest is a tax deductible expense.
Because firms with leverage have fewer shares outstanding.
a.Because interest payments on debt vary with EBIT levels such that low EBIT leads to the lowest interest payments.
b.Because interest payments on the debt stay fixed, leaving the remaining income to be distributed among less shares of stock
c.Because risk units of debt are likely to be lower than risk units assigned to equity
d.Because other things equal, more taxes are paid under the levered capital structure than under an unlevered capital structure
e.Because interest payments on debt can be put off until some date in the future such as the date of debt maturity
Explanation / Answer
1) When comparing levered versus unlevered capital structures, why does leverage
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