FINS 1613 Tutorial Week 11 QAs (Ch 13)

FINS 1613 Tutorial Week 11 QAs (Ch 13) - Tutorial Week 11...

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Tutorial Week 11 (based on week 10 lecture and assigned readings – Text chapters 13) Chapter 13: Leverage and Capital Structure Concepts Review and Critical Thinking Questions: 1, 2, 3, 4, 5, 6, and 8. 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 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. 2. 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. This is true in both a classical tax system and in an imputation system this is also true, however the use of debt is of marginal benefit depending on the shareholders ability to use the franking credits. 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 that maximises 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. Generally most industries have lower debt ratios than overseas industries due to the effects of imputation. The more capital intensive industries, such as electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such computers or drugs, tend to use less. Such industries also have a higher concentration of growth and startup
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This note was uploaded on 01/09/2012 for the course FINS 1613 taught by Professor Drkhshim during the Three '10 term at University of New South Wales.

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FINS 1613 Tutorial Week 11 QAs (Ch 13) - Tutorial Week 11...

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