FINANCIAL LEVERAGE AND CAPITAL
Answers to Concepts Review and Critical Thinking Questions
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 leverage.
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
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.
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.
It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.
Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level.
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 process.
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
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 keep in mind is that the bankruptcy code is