Chapter 6
2. Operating leverage is the substitution of fixed- for variable-cost methods of production. With
operating leverage, sales must increase to cover the higher fixed costs, but once covered, profits
One would not expect to find both high operating leverage and high financial leverage at the
4. Companies can incur significant costs of financial distress without going bankrupt. In fact,
these costs are often much larger than the cost of bankruptcy itself. Costs include lost profit
opportunities due to cut backs in investment, R&D, and marketing to conserve cash. They also
6. There are two reasons. First, the costs of high debt are comparatively low to such companies
because the resale value of their assets is typically high and they have few worries about
8. a. The customer’s equity investment is $10. The expected investment payoff is $106.
Repaying $90 in principal and $3.60 in interest, the residual payoff to the customer is
b. Unless borrowing somehow increases the expected $106 payoff from the investment, it
c. The Irrelevance Proposition says the same thing more formally: Unless leverage affects an
10. a. Market signaling studies suggest that the price of existing FARO shares will fall. One
current price.
b. Expected loss = 30% of issue size = 0.3*($200 million) = $60 million.
12. a. Because there is no debt outstanding, Firm value = Equity value = 100 million x $20 = $2
billion.
c. Equity investors neither gain nor lose from the recap. Before the recap, equity value is $2
repurchase also received $20 cash for each share.)
d. Market value of firm = $2 billion + $100 million = $2.1 billion. Market value of equity =
by the recap accrues to shareholders.
e. Equity investors indeed gain from the recap in this revised scenario. The leveraged recap
all of the increased value accrues to the owners.
14. See Excel solutions at mhhe.com/higgins11e.