Question

1. TRUE OR FALSE By accepting a lot of capital budgeting projects with a high level of fixed costs I can inadvertently increase my operating leverage and business risk to the firm.
2. TRUE OR FALSE The higher the debt, the higher the financial risk, but since you decrease the # shares and equity you should see higher EPS and ROE.
3. TRUE OR FALSE A firm should pay out a dividend if they cannot earn a better rate of return than the stockholder and the clientele effect is when a firm reduces a dividend and investors are indifferent.
4. TRUE OR FALSE A firm has a decent coverage ration if has EBIT of 10 million and interest expense of 10.5 million
5. TRUE OR FALSE If the current ratio is above 1, a firm can meet its short term obligations.

Answer 1

a)

"By accepting a lot of capital budgeting projects with a high level of fixed costs I can inadvertently increase my operating leverage and business risk to the firm"

This statement is True as high operating leverage implies high fixed costs. For example, a firm having high fixed costs will need to cover the fixed costs by selling as many units as possible in terms of volume to cover the fixed cost to add to the bottom line.

b)

"The higher the debt, the higher the financial risk, but since you decrease the # shares and equity you should see higher EPS and ROE."

Higher debt implies more statutory liabilities in terms of interest outgo irrespective of the cash generated by the firm thus increasing the risk for the firm. However, a higher debt replacing the existing equity would increase the EPS for number of shares in the denominator and higher ROE as lesser equity is in the denominator.

Answer is True

c)

"A firm should pay out a dividend if they cannot earn a better rate of return than the stockholder and the clientele effect is when a firm reduces a dividend and investors are indifferent"

The answer is True as the investor can use the dividend proceeds to earn better return elsewhere.

d)

"A firm has a decent coverage ratio if has EBIT of 10 million and interest expense of 10.5 million"

For a firm to have decent coverage ratio, EBIT has to be large enough such that it covers the interest expense. In the above case, EBIT< Interest expense. So statement is False

e)

" If the current ratio is above 1, a firm can meet its short term obligations."

For a firm to be comfortable on the liquidity front, the current ratio has to be > 1 such that the current assets can be sold to pay off the current liability.

TRUE