Question

How can an unlevered firm obtain financial leverage? Select one: O a. By issuing common stock O b. By issuing debt O c. By retaining its earnings in the firm O d. By investing in positive NPV investments x O e. By investing in negative NPV projects
Which best defines the term "perfect markets"? Select one: O a. Markets that operate under highly restrictive assumptions such as zero taxes O b. Markets that offer the highest returns for a given level of risk x O c. Markets where levered firms have advantages versus unlevered firms O d. Markets where dividends are preferred to capital gains O e. Markets where firms will design elaborate capital structures such as Euro bonds
The chapter on financial leverage uses "risk units" to illustrate what about financial leverage? Select one: O a. That firm value is maximized where the cost of capital is minimized. O b. That debt financing creates a tax shield and therefore lowers firm risk. O c. That the risk of the firm's assets cannot be changed by shifts in financial leverage. O d. That debt is risk free. O e. That for firms with leverage, the higher the EBIT, the higher is firm risk. x

Answer 1

Financial leverage is the use of borrowed money to increase production volume and thus the earnings. The more the debt in the company's capital structure, the ore the financial capital. Therefore, an unlevered firm can obtain financial leverage b) by issuing debt.

Perfect markets are characterized by many buyers and sellers, undifferentiated products and no transaction costs. So a) they are the markets under highly restrictive assumptions such as zero taxes.

The use of leverage increases stock volatility which in turn increases the level of risk. The cost of debt is usually lower than the cost of equity. Therefore, a) The firm value is maximized where the cost of capital is minimized