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BFM1014 FUNDAMENTALS OF FINANCE
Trimester 1, 2015-2016

BFM1014 FUNDAMENTALS OF FINANCE
Trimester 1, 2015-2016

CHAPTER 13 LEVERAGE AND CAPITAL STRUCTURE
Concepts Review and Critical Thinking Questions 1. Explain what is meant by business and financial risk. Suppose Firm A has greater risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain. 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. 3. Is there an easily identifiable debt equity ratio that will maximize the value of a firm? Why or why 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. 10. What is the basic goal of financial management with regards to capital structure? As with any management decision, the goal is to maximize the value of shareholder equity. To accomplish this with respect to the capital structure decision, management attempts to choose the capital structure with the lowest cost of capital.

Questions and Problems
1. Keala, Inc has no debt outstanding and a total market value of $125,000. EBIT are projected to be $10,400 if economy are normal. If there is strong expansion in the

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