32 Lecture - Financial leverage and capital structure

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32 Lecture

MGT201

Midterm & Final Term Short Notes

Financial leverage and capital structure

Financial leverage refers to the use of debt financing to fund a company's operations, which can impact a company's return on equity (ROE) and overall financial performance. Capital structure refers to the mix of debt and equity financing that a


Important Mcq's
Midterm & Finalterm Prepration
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  1. What is financial leverage? a. The use of debt financing to fund a company's operations b. The use of equity financing to fund a company's operations c. The use of short-term financing to fund a company's operations Answer: a

  2. Which of the following can be impacted by a company's financial leverage? a. Return on equity (ROE) b. Return on assets (ROA) c. Both A and B Answer: c

  3. What is capital structure? a. The mix of debt and equity financing used by a company b. The amount of debt financing used by a company c. The amount of equity financing used by a company Answer: a

  4. Which of the following can impact a company's capital structure? a. Market conditions b. Industry competition c. Both A and B Answer: c

  5. What is the cost of capital? a. The cost of debt financing b. The cost of equity financing c. The overall cost of a company's financing Answer: c

  6. What is the break-even point? a. The point at which a company generates enough revenue to cover its fixed and variable costs b. The point at which a company generates enough revenue to cover its fixed costs only c. The point at which a company generates enough revenue to cover its variable costs only Answer: a

  7. Which of the following can impact a company's cost of capital? a. Interest rates b. Company size c. Both A and B Answer: a

  8. Which of the following is a benefit of debt financing? a. Lower cost of capital b. No risk of bankruptcy c. No interest payments Answer: a

  9. Which of the following is a risk of debt financing? a. Potential for bankruptcy b. Higher cost of capital c. Both A and B Answer: c

  10. What is the optimal capital structure for a company? a. 100% debt financing b. 100% equity financing c. A mix of debt and equity financing that balances the benefits and risks of each Answer: c



Subjective Short Notes
Midterm & Finalterm Prepration
Past papers included

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  1. What is financial leverage and how does it impact a company's return on equity (ROE)? Answer: Financial leverage refers to the use of debt financing to fund a company's operations. When a company uses debt, it can amplify its returns on equity, but it also increases the risk of losses. The impact of financial leverage on ROE depends on the company's ability to generate returns that exceed the cost of debt.

  2. How does a company's capital structure impact its cost of capital? Answer: A company's capital structure, or the mix of debt and equity financing it uses, can impact its cost of capital. Generally, using more debt financing can lower a company's cost of capital, but also increase its risk. Using more equity financing can increase a company's cost of capital, but also decrease its risk.

  3. What is the break-even point and how does it relate to a company's capital structure? Answer: The break-even point is the point at which a company generates enough revenue to cover its fixed and variable costs. A company's capital structure can impact its break-even point by affecting the amount of fixed costs it has. Using more debt financing can increase a company's fixed costs, while using more equity financing can decrease them.

  4. What are the benefits of using debt financing? Answer: Some benefits of using debt financing include lower cost of capital, tax advantages, and the ability to leverage returns on equity.

  5. What are the risks of using debt financing? Answer: Some risks of using debt financing include the potential for bankruptcy, the need to make interest payments, and the risk of default if the company is unable to make payments.

  6. How does a company's financial leverage impact its risk profile? Answer: Financial leverage can increase a company's risk profile by increasing the risk of bankruptcy or default. However, it can also increase the potential for returns on equity.

  7. How can a company determine its optimal capital structure? Answer: A company can determine its optimal capital structure by balancing the benefits and risks of debt and equity financing. This may involve considering factors such as its cost of capital, risk profile, and ability to make interest payments.

  8. How does a company's capital structure impact its ability to raise funds? Answer: A company's capital structure can impact its ability to raise funds by affecting its perceived riskiness to lenders and investors. Generally, a company with more debt financing may be seen as riskier and may have a harder time raising funds than a company with more equity financing.

  9. How can a company adjust its capital structure over time? Answer: A company can adjust its capital structure over time by raising or lowering the amount of debt or equity financing it uses. This may involve refinancing debt, issuing new equity, or repurchasing existing equity.

  10. How does a company's cost of debt and cost of equity financing impact its overall cost of capital? Answer: A company's cost of debt and cost of equity financing are both components of its overall cost of capital. The relative weight of each component in the company's capital structure can impact its overall cost of capital. Generally, the higher the proportion of debt financing, the lower the overall cost of capital, but also the higher the risk.

Financial leverage and capital structure are two essential components of financial management that can significantly impact a company's profitability and risk level. Financial leverage refers to the use of debt to finance a company's operations, which can increase a firm's potential returns but also its financial risk. Capital structure, on the other hand, refers to the mix of debt and equity financing that a company uses to fund its operations. In general, companies that rely heavily on debt financing have higher financial leverage, which can lead to higher returns on equity (ROE) but also increase the risk of bankruptcy. This is because debt holders have a priority claim on a company's assets, meaning that they will be paid back before equity holders in the event of bankruptcy. When companies raise capital, they must choose an optimal capital structure that balances the benefits of using debt (such as lower cost of capital and potential tax benefits) with the costs of higher financial risk. This involves analyzing the company's current financial leverage and determining the optimal mix of debt and equity financing to maximize shareholder value. To assess a company's financial leverage and capital structure, analysts use various financial ratios, such as debt-to-equity ratio, debt-to-assets ratio, and interest coverage ratio. These ratios can help investors and managers understand a company's risk level and its ability to meet its debt obligations. In conclusion, understanding financial leverage and capital structure is critical for making sound financial decisions and managing risk in a company. While high financial leverage can lead to higher returns, it can also increase a company's financial risk, so it's important to find the right balance between debt and equity financing.

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