QUESTIONS FROM CHAPTER 12:
12-1 Explain why the following is true: �Other things the same, firms with relatively stable sales are able to carry relatively high debt ratios.�
ANS: Stable sales means low business risk. If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges (interest expense) will also vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.
12-2 Why do public utilities pursue a different financial policy than retail firms?
Key factors to consider: Business Risk and Asset Type
Debt in general, esp. Long-term debt. Public utilities place greater emphasis on long-term debt because they have more stable sales and profits as well as more fixed assets.
Current liabilities. Retail firms place more emphasis on current liabilities because they have greater inventories and receivables.
12-3 Why is EBIT generally considered to be independent for financial leverage? Why might EBIT actually be influenced by financial leverage at high debt levels?
ANS: EBIT (operating income) depends on sales and operating costs which generally are not affected by the firm�s use of financial leverage, since interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financial difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm�s future.
12-4 If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
ANS: The tax benefits from debt increase linearly, which causes a continuous increase in the firm�s value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-8 in the textbook.
12-7 Assume that you are advising the management of a firm that is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one, and it must also choose a capital structure for financing the expansion. Should the asset investment and financial decisions be jointly determined, or should each decision be made separately? How would these decisions affect one another? How could the leverage concept be used to help management analyze the situation?
Ans: The firm may want to assess the asset investment and financing decisions jointly. For instance, the highly automated process would require fancy, new equipment (capital intensive) so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. If sales fell, the process which demands more fixed costs might be detrimental to the firm if it has much debt financing. The less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped; thus, debt financing would be more attractive. Operating leverage and financial leverage are interrelated. The highly automated process would increase the firm�s operating leverage; thus, its optimal capital structure would call for less debt. On the other hand, the less automated process would call for less operating leverage; thus, the firm�s optimal capital structure would call for more debt.
12-8 Your firm�s R&D department has been working on a new process which, if it works, can produce oil from coal at a cost of about $5 per barrel versus a current market price of $20 per barrel. The company needs $10 million of external funds at this time to complete the research. The result of the research will be known in about a year, and there is about a 50-50 chance of success. If the research is successful, your company will need to raise a substantial amount of new money to put the idea into production. Your economists forecast that although the economy will be depressed next year, interest rates will be high because of international monetary problems. You must recommend how the currently needed $10 million should be raised --- as debt or as equity. How would the potential impact of your project influence your decision?
ANS: Several possibilities exist for the firm, but trying to match the length of the project with the maturity of the financing plan seems to be the best approach. The firm may want to finance the R&D with short-term debt and then, if the project�s results are successful, to raise the needed capital for production through long-term debt or equity. Another possibility would be to issue convertible bonds, which can be converted to common stock -- a lower interest rate would be paid now, and in the future (presumably the stock price will increase with the new process) investors would trade in the bonds for stock. One should also keep in mind that this project, and R&D in general, is extremely risky and debt financing may not be available except at extremely high rates. For this reason, many R&D companies have low debt ratios, instead paying low dividends and using retained earnings for financing projects. Beware of the ASSET TYPE: Tangible assets hold value in bankruptcy, so they would have good collateral value against loans. Intangible assets (R&D, etc.) do not, so they are funded with equity, not debt.
12-8 Explain how profits or losses will be magnified for a firm with high operating leverage as opposed to a firm with lower operating leverage.
ANS: Here you should remember the example from th handout: Data below are for years 1 and 2:
Year 1 Year 2
EBIT 100 120
Fixed Interest Expense- 80 -80
EBT 20 40
EBIT increased by 20%, EBT (NI before tax) increased by 100%. It works the same way if EBIT had gone down (i.e., EBT would go down by a greater 100%.) Leverage magnifies earnings or losses.
12-11 MODIFIED: What would be the effect of each of the following on the amount of debt in firm�s capital structure?
a. Corporate tax rates are doubled
This increases debt financing because there would be greater value to the tax benefit (shield) of using debt.
b. A high tech firm merges with a food firm.
Business risk goes down, more debt financing would be used as business risk goes down.
c. A change from straight line depreciation to the MACRS method with no change in the beginning amount of fixed assets
A distracter having no effect!