2 The central issue underlying the study of leverage is whether or not it

2 the central issue underlying the study of leverage

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2. The central issue underlying the study of leverage is whether or not it influences stock price and whether there's an optimal structure. But the whole idea seems kind of fuzzy and uncertain. Why are people so interested? ( Hint : Think of management's goals and of the world of mergers.) ANSWER: A great deal of money can be made very quickly if a change in leverage can have an immediate and substantial impact on stock price. In merger situations, acquiring firms often borrow the money to purchase firms being acquired. If the resulting increase in leverage of the combined organization has a positive effect on stock price, the stockholders of both companies can get rich virtually overnight. 3. Relate business and financial risk as defined in this chapter to the risks described in Chapter 9. ANSWER: The risks discussed in this chapter relate to variations in a firm's financial results. Business risk is variation in EBIT. Financial risk is the increase in variation found between EBIT and EPS and ROE if financial leverage is present. In other words, these risks are found within the firm's financial statements. The concepts in Chapter 9 were broader in that they addressed an investor's return. That return can be influenced by recorded financial results as well as by other things that don't show up on a company's books. For example, an economic recession depresses stock prices and therefore investor returns, but may not influence profitability as seen in EBIT, ROE or EPS. The risks in Chapter 9 include the risks discussed here. 4.Why are ROE and EPS such important measures of performance to investors? 5.Both business risk and financial risk would exist with or without either type of leverage. Leverage just makes them more significant. Are these statements true or false? Explain.
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