5.14 Review Questions: Chapter Five

Review Questions: Chapter Five

  1. What effect does Financial Leverage have on Net Income, Earnings per Share, and Return on Equity? Explain.
  2. Financial Leverage modifies the relationships between _____ and _____.
  3. When observing the slope of the EBIT/ROE (or the EBIT/EPS) line, a steeper slope represents lesser / greater leverage. (Remember: EBIT is on the horizontal axis.) Which is it? Why?
  4. Under what circumstance is leverage advised or ill-advised?
  5. Calculate the Crossover Point, given the following:
    • Total Capital $2.5 million
    • 100,000 shares outstanding, assuming no debt
    • YTM = 5%
    • Tax Bracket = 35%
    • Interest Rate = 6%
    • There is no preferred stock
  1. In the prior question, state not just the EBIT, but its consequent levels of ROE and EPS.
  2. This text solves the question of the Crossover Point by reference to ROE. Present the parallel formula using EPS.
  3. If debt is cheapest, why not use it to the max?
  4. List and discuss the merits and demerits of using debt in a firm’s capital structure.
  5. How does debt interact with Operating Risk, if at all? Explain.
  6. A guiding principle in determining the optimal level of debt has to do with minimizing the firm’s Weighted Average Cost of Capital. Explain.
  7. Another guiding principle has to do with maximizing the firm’s value. Explain.
  8. What four variables are relevant in determining the firm’s actual degree of leverage? Explain.
  9. What is meant by External Funds Needed?
  10. What are Internal and External Funds?
  11. Why is the notion of External Funds Needed so very important?



Selected Answers

Question 5:

It does not matter what amount of leverage you assume; the crossover point will be the same for all amounts of leverage. Let us assume 50%. Why not?

(EBIT) (.65) / 2,500 = (EBIT- 75) (.65) / 1,250

EBIT = 150

Question 6:

ROE = (150) (0.65) / 2,500 = 0.039

EPS = (150) (0.65) / 100 = $0.975



Icon for the Creative Commons Attribution 4.0 International License

Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

Share This Book