Financial leverage ratios tend to be to low in countries that have: A) a high reliance on the banking system for raising debt capital. B) a large institutional investor presence. C) inefficient legal systems. – Which of the following types of firms is most likely to have a high degree of operating leverage? A) A fine clothing retailer. B) A restaurant. C) A firm that develops and sells complex software.
- C) inefficient legal systems.
- B 2. A???
A, B ?
B. Large institutional presence favours equity capital. Inefficient legal systems will favour higher debt ratios since enforcing efficient practices will be more difficult (basically people can get away with shit more easily) C. Because it will have high fixed costs as opposed to the other 2 which will have high VC.
yeah chad nailed it 1-Your answer: C was incorrect. The correct answer was B) a large institutional investor presence. Firms operating in countries with an active, large institutional investor presence tend to have less financial leverage. Large institutional investors tend to have greater resources to analyze companies and reduce information asymmetries, which reduces the use of debt. By contrast, companies with weak legal systems and a high reliance on the banking system will all tend to have higher debt ratios. 2-Your answer: A was incorrect. The correct answer was C) A firm that develops and sells complex software. Firms that tend to have high operating leverage are those that invest up front to produce a product, but have low variable costs when it comes to distributing the product. A software development firm will have to spend a great deal of money up front to create the software, but the costs of distributing the software will be relatively low. Retailers and restaurants are more likely to have a variable cost structure, which would imply low operating leverage.
C- Because of what CP said… A - Clothing retailer, higher fixed costs in manufacturing
I don’t like questions like these…If the legal system is bad, then you won’t have lots of equity either, so D/E could be high! If there is no debt market (only banks) there is little debt available for borrow.
Is there a good way to memorize this stuff? I forget these little details quite often.
cre_analyst Wrote: ------------------------------------------------------- > A - Clothing retailer, higher fixed costs in > manufacturing That’s exactly what I thought, but I don’t know jack about the restaurant or clothing industry! Thought you’d be able to capitalize R&D for software company, thus less FC.
How will a clothing retailer have high fixed costs? Are you confusing it with a clothing manufacturer perhaps?
My years in college working in restaurants are beginning to pay off! The software company probably has higher fixed costs relative to the restaurant
> The software company probably has higher fixed costs relative to the restaurant The comparison is not in absolute dollar amounts, but relative to overall cost. A restaurant has a higher fixed cost than a few geeks in a basement cranking out software.
good point.
The software company has higher operating leverage cuz all it needs to do is put in the time, effort and money into developing ONE software. Think of it as sales are spread over a ONE TIME fixed cost. With a restaurant you have to keep on replenishing ingredients and updating menus, etc etc which increase as your sales increase (the more people you serve, the more ingredients you will need to cook the food you sell). With a software co. this isn’t the case.
Which of the following most accurately describes how the use of debt affects the value of a firm? a. Adding more debt to a company’s capital structure and reducing equity will always increase a firm’s ROE and EPS. b. Financial leverage should be employed only if a firm’s cost of equity capital is greater than its cost of debt capital. c. If the pretax cost of debt is less than the operating return on assets, then adding more debt to reduce equity will increase the firm’s ROE and EPS. ----- Leverage always provides firms with: a. Enhanced earnings per share when firms expect to have earnings before interest and taxes below their financing breakeven point. b. Enhanced earnings per share when firms expect to have earnings before interest and taxes above their financing breakeven point. c. Lower earnings per share than unleveraged firms.
second set from supersharp - c,b? earlier set from super sharp - cp, i agree with you, a weak legal system to me suggests less debt. that’s thinking about it from a bankruptcy/contract law perspective though, and i think you’re supposed to assume that a presence of greater institutional investors results in more resources to evaluate riskier securities (equity vs debt). any company with high fixed costs has higher operating leverage - think R&D and capex (biotech, software).
yep you nailed it on the 2nd set ridge Choice “c” is correct. This is a correct statement because the firm will earn more than the cost of debt and this will increase the firm’s profitability. The debt is used to reduce equity; thus, the ROE and EPS will rise. Choice “b” is correct. Leveraged firms produce higher EPS if their EBIT is above their financing breakeven point and lower EPS if their EBIT is below their financing breakeven point.