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
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 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.
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.
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