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Unformatted text preview: Answers to End-of-Chapter Questions 14-1 Operating leverage is the extent to which fixed costs are used in a firms operations. If operating leverage is increased (fixed costs are high), then even a small decline in sales can lead to a large decline in profits and in its ROE. 14-2 a. The breakeven point will be lowered. b. The effect on the breakeven point is indeterminant. An increase in fixed costs will increase the breakeven point. However, a lowering of the variable cost lowers the breakeven point. So its unclear which effect will have the greater impact. c. The breakeven point will be increased because fixed costs have increased. d. The breakeven point will be lowered. 14-3 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations, or relatively stable sales. 14-4 An increase in the personal tax rate makes both stocks and bonds less attractive to investors because it raises the tax paid on dividend and interest income. Changes in personal tax rates will have differing effects, depending on what portion of an investments total return is expected in the form of interest or dividends versus capital gains. For example, a high personal tax rate has a greater impact on bondholders because more of their return will be taxed sooner at the new higher rate. An increase in the personal tax rate will cause some investors to shift from bonds to stocks because of the attractiveness of capital gains tax deferrals. This raises the cost of debt relative to equity. In addition, a lower corporate tax rate reduces the advantage of debt by reducing the benefit of a corporations interest deduction that discourages the use of debt. Consequently, the net result would be for firms to use more equity and less debt in their capital structures. 14-5 a. An increase in the corporate tax rate would encourage a firm to increase the amount of debt in its capital structure because a higher tax rate increases the interest deductibility feature of debt. b. An increase in the personal tax rate would cause investors to shift from bonds to stocks due to the attractiveness of the deferral of capital gains taxes. This would raise the cost of debt relative to equity; thus, firms would be encouraged to use less debt in their capital structures....
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