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Impact of Leverage on Business Risk & Capital Structure, Quizzes of Entrepreneurship

Definitions and insights into key concepts related to business risk and capital structure, including operating leverage, financial leverage, tax shields, and the impact of debt on business and financial risk. It also covers various capital structure theories and their assumptions.

Typology: Quizzes

2010/2011

Uploaded on 12/06/2011

christianede7
christianede7 🇺🇸

62 documents

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TERM 1
define: Business Risk
DEFINITION 1
Risk if firm uses no debt. Any other business related factors:
demand (unit sales);
output prices; input costs
TERM 2
when does a firm have high operating
leverage?
DEFINITION 2
if a high percentage of firm's costs are fixed and don't
decline when demand falls.
TERM 3
does high operating leverage affect business
risk
DEFINITION 3
YES it increases its business risk
TERM 4
define: a) financial leverage b) operating
leverage
DEFINITION 4
a) extent of fixed income securities (debt and preferred
stock)b) extent of fixed and variable costs used by a firm
TERM 5
The higher the proportion of fixed costs
relative to variable costs
DEFINITION 5
the higher the operating leverage.
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define: Business Risk

Risk if firm uses no debt. Any other business related factors: demand (unit sales); output prices; input costs TERM 2

when does a firm have high operating

leverage?

DEFINITION 2 if a high percentage of firm's costs are fixed and don't decline when demand falls. TERM 3

does high operating leverage affect business

risk

DEFINITION 3 YES it increases its business risk TERM 4

define: a) financial leverage b) operating

leverage

DEFINITION 4 a) extent of fixed income securities (debt and preferred stock)b) extent of fixed and variable costs used by a firm TERM 5

The higher the proportion of fixed costs

relative to variable costs

DEFINITION 5 the higher the operating leverage.

business risk depends on? financial risk

depends on?

Business risk: depends on business factors such as competition, operating leverage, etc. Financial risk: depends the amount of debt and preferred stock financing. TERM 7

define: financial risk

DEFINITION 7 additional risk of using more debt Additional risk concentrated on common stockholders when financial leverage is used. TERM 8

T/F: by increasing debt, you increase your

expected risk and your expected return

DEFINITION 8 True TERM 9

Why does leveraging increase your return?

DEFINITION 9 More cash goes to investors less taxes TERM 10

what are 4 Capital Structure Theories

DEFINITION 10 MM, trade-Off, Signaling, and Pecking Order

MM theory on "personal taxes"

proves

Presence of personal taxes reduces advantage of debt financing. Use of debt financing remains advantageous, but benefits are less. BUT firms should still use 100% debt. Tax rates of investors would adjust until there was no advantage to debt. TERM 17

T/F: according to MM Investors are willing to

accept debt over equity.

DEFINITION 17 False! Investors prefer equity, corporations prefer debt TERM 18

Tradeoff theory says

DEFINITION 18 Debt adds value bc it's tax deductible BUT it also brings costs (bankruptcy costs) Optimal capital structure= balance b/w bankruptcy costs and tax benefits At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. TERM 19

according to tradeoff theory, what's the

optimal capital structure

DEFINITION 19 An optimal capital structure exists at balance of bankruptcy costs and tax benefits. TERM 20

T/F: Firms that add additional equity sends a

positive signal to investors

DEFINITION 20 FALSE!!! sends a negative signal price is overvalued

T/F: Firms that add additional debt sends a

positive signal to investors

Somewhat true Mostly positive bc reflects stock price is undervalued but too much debt could give bad impression TERM 22

Signaling theory assumes

DEFINITION 22 Investors have asymmetrical info (managers have better information to forecast FCF's) MM says they have symmetrical info (or investors and managers have same information) TERM 23

Signaling theory

concludes

DEFINITION 23 That since managers have better info they will: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. TERM 24

pecking order theory

DEFINITION 24 Firms pay capital costs through internally generated funds (RE) first, because there are no flotation costs or negative signals. Then debt (because it has lower flotation costs than equity and no negative signals.) As a last (final) resort, firms then issue equity. TERM 25

T/F: Firms should issue dividends if they issue

a lot of debt.

DEFINITION 25 FALSE

define: underinvestment

High debt increases risk of financial distress and therefore, managers may avoid positive NPVs projects TERM 32

Having too much debt (or leverage) causes

management to be

DEFINITION 32 Risk averse OR very risky (Hail Mary pass) TERM 33

by increasing debt, you ____ your expected

return

DEFINITION 33 Increase (Vegas example) TERM 34

a) formula: tax shield b) which part is the

annual tax shield? c/d) what does each

variable mean?

DEFINITION 34 a) CFL = CFU + rdDT b) RdDT c) CFL=CF to Firm L; CFU= CF to Firm U; Rd=cost of debt; d) D= total amount of debt; T= tax shield TERM 35

formula: perpetuity

DEFINITION 35 PMT/r

T/F: more debt= more tax shield

TRUE

TERM 37

in real life why if the MM theory wrong?

DEFINITION 37 it ignores bankruptcy costs and other stutch TERM 38

T/F: value of firm will peak at equilibrium

point but if you keep using debt after that

point, value of firm will increase.

DEFINITION 38 FALSE!!! Value of firm will decrease as you move right on the graph and use more debt. TERM 39

impact on capital structure depends on effect

of debt on:

DEFINITION 39 WACC FCF TERM 40

with debt's interest expense being tax

deductible, what 3 benefits result?

DEFINITION 40 Reduces taxes paid Reduces AT Return on Debt Frees up more cash

As weight on debt increases,

risk

increases TERM 47

As weight on debt increases, cost/return of

equity

DEFINITION 47 increases because shareholders require a higher rate TERM 48

As weight on debt increases,

taxes

DEFINITION 48 decrease TERM 49

As weight on debt increases, risk of

bankruptcy

DEFINITION 49 increases TERM 50

As risk of bankruptcy increases, AT cost of

debt

DEFINITION 50 decreases

what are the direct and indirect costs of

"bankruptcy"

Direct: legal fees, "fire"sales Indirect: lost customers, employees looking for jobs, lower productivity, reduced credit TERM 52

As risk of bankruptcy increases, free cash flow

and NOPAT

DEFINITION 52 both decrease TERM 53

As risk of bankruptcy increases, agency costs

DEFINITION 53 decrease this is good- managers will have more pressure to perform so they wont be flying off in their corporate jets TERM 54

a) Wd also called b) We also called c)

Relationship?

DEFINITION 54 a) low cost debt b) high cost equityc) common sense: As Wd increases, We decreases TERM 55

whats a firms "optimal" capital structure

DEFINITION 55 mix of debt and equity that maximizes firms value (stock price)

T/F: if there are only corporate taxes, M and

M showed that a firm's value increases as it

adds debt

True TERM 62

how can companies avoid issueing new

stock?

DEFINITION 62 Reserve borrowing capacity using less debt TERM 63

T/F: firms owners may use large amounts of

debt to constrain managers

DEFINITION 63 True Why? bankrupcy costs forces managers to be more careful TERM 64

T/F: High debt ratio raises threat of

bankruptcy

DEFINITION 64 True