Leverage and capital structure chapter 13 solutions - Essay Example

Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will lead to high total leverage. The following equation explains the relationship between the degree of total leverage and the degrees of both operating and financial leverage. Poor capital structure decisions can result in high cost of capital, thereby lowering the NPVs of projects. On the other hand, effective capital structure decisions can lower the cost of capital leading to higher NPVs thereby increasing the value of the firm.

All the items on the right hand side of the balance sheet, excluding current liabilities are sources of capital. The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. The more debt and preferred stock a firm has in its capital structure, the greater its financial leverage and risk. The penalty for not meeting financial obligations is bankruptcy. Managers of firms typically act as agents of owners.

The owners give the managers the authority to manage the firm for the owners’ benefit. The agency problem created by this relationship extends to the relationship between owners and lenders. Lenders can control the firm’s risk and protect themselves against adverse effects of the agency problem by including appropriate provisions in loan agreements. On the other hand, firms benefit by obtaining funds at lower costs by agreeing to the financial and operating constraints placed by loan provisions.

A signal is a financial action by management that is believed to reflect its view of the firm’s stock value. Generally, debt financing is viewed as a positive signal that management believes the stock is under-valued while a stock issue is viewed as a