CAPITAL STRUCTURE AND LEVERAGE
Debt: Rocket Booster or Anchor?
Define optimal capital structure and differentiate it from target
capital structure.
What four factors influence the target capital structure?
In what sense does setting the target capital structure involve a
trade-off between risk and return?
Why might market conditions cause a firm’s actual capital structure
to vary from its target?
What is business risk, and how can it be measured?
What are some determinants of business risk?
Why does business risk vary from industry to industry?
What is operating leverage?
How does operating leverage affect business risk?
What is financial risk, and how does it arise?
Explain this statement: “Using leverage has both good and bad
effects.”
What happens to the component costs of debt and equity when the
debt ratio is increased? Why does this occur?
Using the Hamada equation, explain the effects of financial leverage
on beta.
What is the equation for calculating a firm’s unlevered beta?
Use the Hamada equation to calculate the unlevered beta for Firm X
with the following data: bL 1.25; T 40%; Debt/Assets 0.42;
Equity/Assets 0.58. (b U 0.8714)
What would the cost of equity be for Firm X at Equity/Assets ratios
of 1.0 (no debt) and 0.58, assuming that rRF 5% and RPM 4%?
(8.49%, 10%)
Using a graph and illustrative data, discuss the premiums for finan-
cial risk and business risk at different debt levels. Do these premi-
ums vary depending on the debt level? Explain.
Is expected EPS generally maximized at the optimal capital structure? Explain
Why does MM’s theory with taxes lead to 100 percent debt?
How would an increase in corporate taxes tend to affect firms’ capital structures? What about personal taxes?
Explain what asymmetric information means, and how signals affect
capital structure decisions.
What is meant by reserve borrowing capacity, and why is it important to firms?
How can the use of debt serve to discipline managers?
How does sales stability affect the target capital structure?
How do the types of assets used affect a firm’s capital structure?
How do taxes affect the target capital structure?
How do lender and rating agency attitudes affect capital structure?
How does the firm’s internal condition affect its actual capital
structure?
What is financial flexibility, and is it increased or decreased by a
high debt ratio?
Why do wide variations in the use of financial leverage occur both
across industries and among individual firms in each industry?