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CHAPTER 16
FINANCIAL LEVERAGE AND CAPITAL
STRUCTURE POLICY
Answers to Concepts Review and Critical Thinking Questions
1. 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
2. No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember
3. 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
4. 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
5. It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
6. Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate
level.
7. 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
8. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the
CHAPTER 16 B-277
9. One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
bankruptcy filing enabled Continental to restructure and keep flying. The other side is that Continental
abused the bankruptcy code. Rather than renegotiate labor agreements, Continental simply abrogated
them to the detriment of its employees. In this, and the last several, questions, an important thing to
10. The basic goal is to minimize the value of non-marketed claims.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.
Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1. a. A table outlining the income statement for the three possible states of the economy is shown
below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows the
percentage change in EPS the company will experience in a recession or an expansion economy.
Recession Normal Expansion
EBIT $14,000 $28,000 $36,400
Interest 0 0 0
NI $14,000 $28,000 $36,400
EPS $ 2.80 $ 5.60 $ 7.28
%EPS –50 ––– +30
b. If the company undergoes the proposed recapitalization, it will repurchase:
Share price = Equity / Shares outstanding
Share price = $250,000/5,000
Share price = $50
Shares repurchased = Debt issued / Share price
Shares repurchased =$90,000/$50
Shares repurchased = 1,800
