FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
LO1 The effect of financial leverage on firm value and cost of capital.
LO2 The impact of taxes and bankruptcy on capital structure choice.
LO3 The essentials of the bankruptcy process.
Answers to Concepts Review and Critical Thinking Questions
1. (LO1) Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly
related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the
firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial
risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater
2. (LO1) No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to
remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt,
the WACC does not necessarily rise.
3. (LO1) Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot
easily be identified or quantified, it’s practically impossible to determine the precise debt/equity ratio that
maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more
expensive, it’s probably true that the firm is too highly leveraged.
4. (LO1) The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use
greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs,
tend to use less financial leverage. Such industries also have a higher concentration of growth and startup
firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more
predictable future earnings to use more debt financing. These are typically the firms with the greatest need for
external financing and the greatest likelihood of benefiting from the interest tax shelter.
5. (LO1) It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
6. (LO1) Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate
7. (LO3) One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in
shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a
bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the
8. (LO3) As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the
interest charged incorporates it.
9. (LO1, 2) The basic goal is to minimize the value of non-marketed claims.
10. (LO3) The two most basic options are liquidation or reorganization, though creative alternatives may exist.
11. (LO3) g, f, d, b, c, a, e.