PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
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Chapter 18, Problem 26PS
Summary Introduction
To discuss: The right measure of debt ratio and proposal of trade off theory and pecking order theory.
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A profitability measure of ROE is affected by the level of a firm’s debt. Thus,an investor must consider the debt-equity ratio to evaluate the firm’sprofitability. The debt-equity ratio determines a firm’s financial leverage whichindicates how much of assets the firm is able to deploy for each monetary unitof stockholders’ equity.1) Explain how the financial leverage effect can be defined as the differencebetween ROE and ROA. 2) Explain how the financial leverage effect is affected by the debt ratio and theinterest rate.
Debt (or leverage) management ratios
Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds.
Company A uses long-term debt to finance its assets, and company B uses capital generated from shareholders to finance its assets. Which company would be considered a financially leveraged firm?
Company A
Company B
Which of the following is true about the leveraging effect?
Under economic growth conditions, firms with relatively low leverage will have higher expected returns.
Under economic growth conditions, firms with relatively more leverage will have higher expected returns.
Blue Sky Drone Company has a total asset turnover ratio of 3.50x, net annual sales of $40 million, and operating expenses of $18 million (including depreciation and amortization). On its balance sheet and income statement,…
Leverage and the Capital Structure. Why is the use of debt financing referred to as financial “leverage?” What is the basic goal of financial management with regard to the capital structure? Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why or why not?
Chapter 18 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 18 - Prob. 1PSCh. 18 - Tax shields Compute the present value of interest...Ch. 18 - Tax shields Here are book and market value balance...Ch. 18 - Tax shields Look back at the Johnson Johnson...Ch. 18 - Prob. 5PSCh. 18 - Tax shields The firm cant use interest tax shields...Ch. 18 - Prob. 7PSCh. 18 - Tax shields The trouble with MMs argument is that...Ch. 18 - Bankruptcy costs On February 29, 2019, when PDQ...Ch. 18 - Financial distress This question tests your...
Ch. 18 - Prob. 12PSCh. 18 - Agency costs Let us go back to Circular Files...Ch. 18 - Agency costs The Salad Oil Storage (SOS) Company...Ch. 18 - Agency costs The possible payoffs from Ms....Ch. 18 - Prob. 17PSCh. 18 - Prob. 18PSCh. 18 - Prob. 20PSCh. 18 - Pecking-order theory Fill in the blanks: According...Ch. 18 - Financial slack For what kinds of companies is...Ch. 18 - Financial slack True or false? a. Financial slack...Ch. 18 - Debt ratios Rajan and Zingales identified four...Ch. 18 - Leverage targets Some corporations debtequity...Ch. 18 - Prob. 26PSCh. 18 - Trade-off theory The trade-off theory relies on...
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- Calculate the projected debt ratio, debt-to-equity ratio, liabilities-to-assets ratio, times-interest-earned ratio, and EBITDA coverage ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?arrow_forwardLeverage. Suppose that a firm has both floating-rate and fixed-rate debt outstanding. What effect will a decline in market interest rates have on the firm's times interest earned ratio? On the market-value debt-to-equity ratio? On the basis of these answers, would you say that leverage has increased or decreased?arrow_forwardSelect all that are true with respect to the cost of debt. Group of answer choices it is the return the firm needs to earn overall to satisfy all investors It is the rate the debt holders demand given the risk they face as debt holders Can be estimated using CAPM Cannot be estimated using CAPM because CAPM is used for estimating the cost of equity Is always equal to the YTM on a company's existing bonds Is lower than the YTM on a company's existing debt if there is default risk Can be proxied by the YTM on a company's existing debt if the debt is risk free Flag question: Question 7arrow_forward
- You have been asked by your CEO to evaluate, analyse and calculate commonly used ratios relating to a company’s profitability, liquidity, solvency and management efficiency. Requirement: b. Explain how do analysts use ratios to analyse a firm’s leverage? Which ratios convey more important information to a credit analyst those revolving around the levels of indebtedness or those measuring the ability to service debt? What is the relationship between a firm’s level of indebtedness and risk? What must happen in order for an increase in leverage to be successful? Discuss and illustrate all your answer.arrow_forwardWhat are the charateristics of Debt financing and Equity fianancing? If a company wanted to maximize EPS (Earning per Share), which form of financing might they likely consider, debt or equity? Explain.arrow_forwardFinancial leverage measures how much earnings per share (and ROE) respond to changes in debt. True or Falsearrow_forward
- Which of the following statements is false?(a) The quickest way to determine whether a firm has too much debt is to calculate the debt-to-equity ratio.(b) The best guideline to determine the firm's liquidity is to calculate the current ratio.(c) From the investor's point of view, the rate of return on common equity is a good indicator of whether the firm is generating an acceptable return to the investor.( d) We can determine the operating margin by expressing net income as a percentage of total sales.arrow_forwardClass book: Fundamentals of Corporate Finance by Brealey, Myers, and Marcus Interpreting Financial Ratios. In each of the following cases, state which of the two companies is likely to be characterized by the higher ratio. (Hint: think about the likely nature of each firm's business model. For example, would the firm require a lot or a little capital? would it strive for high sales or high profit margins? Does it sell goods for cash or on credit?) a. debt-equity ratio: a shipping company or a computer software company b. ration of sales to assets: an integrated pulp and paper manufacturer or a paper mill c. average collection period: Regional Electric Power Company or Z-Mart Discount Outletsarrow_forward(1) Why do analysts need to consider different factorswhen evaluating a company’s ability to repay shortterm versus long-term debt? (2) Would the currentamount of the owners’ equity be a reasonable price topay for a company? Why or why not?arrow_forward
- You have been asked by your CEO to evaluate, analyse and calculate commonly used ratios relating to a company’s profitability, liquidity, solvency and management efficiency. Explain how do analysts use ratios to analyse a firm’s leverage? Which ratios convey more important information to a credit analyst those revolving around the levels of indebtedness or those measuring the ability to service debt? What is the relationship between a firm’s level of indebtedness and risk? What must happen in order for an increase in leverage to be successful? Discuss and illustrate all your answer.arrow_forwardWhich one of the following factors would likely cause a firm to increase its use of debt financing as measured by the debt to total capital ratio? A.Increased economic uncertainty. B.An increase in the degree of operating leverage. C.An increase in the corporate income tax rate. D.An increase in the price-earnings ratio.arrow_forwardHow can inflation affect the comparability of financial ratios between firms? Explain your answerarrow_forward
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