48. Which of the following are practical difficulties associated with capital st

Question

48. Which of the following are practical difficulties associated with capital structure and degree of leverage analyses?

a. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates (rs values) are affected by different degrees of financial leverage.

b. Managers' attitudes toward risk differ and some managers may set a target capital structure other than the one that would maximize stock price.

c. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability.

d. All of the above.

e. None of the above represent a serious impediment to the practical application of leverage analysis to capital structure determination.

Explanation / Answer

Option A is correct.

At different degree of leverage, it is obvious that cost of equity will change and this will also change the price of the stock. However, it is difficult to estimate the quantum of change and each investor perceive the change in leverage in different manner. Stock markets basically work on sentiments and using behavioural theories it is difficult to make the estimation for correct P/E.

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