Question

1. What is operating leverage? What is financial leverage? Explain how greater operating and financial leverage changes the riskiness of the firm to its shareholders.
2. When estimating the NPV of a project, what are the numerators in the PV formula? What are the denominators? Could the NPV ever be negative? Why? In that event, is the decision “go” or “no go”? Why?
3. Dividends can have a signaling effect. What is the signal from a decision to start paying dividends? Of increasing the dividend? Of cutting the dividend? Why does the market often regard the announcement that a company is planning to issue more shares as a negative sign?
4. Modigliani and Miller (MM) showed that, assuming no taxes or transaction costs, replacing equity with debt in the capital structure would not change the value of the firm, even when the cost of debt is very low. Explain in words or equations (or both) how the MM model produces that result.
5. Explain how incorporating corporate taxes into the MM model changes the conclusion mentioned in question 4. What is the optimal level of debt in the capital structure? Why isn’t it 100% or 0%?

Answer 1

Ans 1) operating leverage is defined as the ratio of contribution margin to net income it is increase by decreasing variable cost and increasing revenue.

Financial leverage is ratio of total debt to total equity. It talks about how much debt and equity is in the capital structure of the company. Increasing the debt is double edge sword because it may increase your ROE during good time but lead into negative net income during worse of your time.

Greater operating leverage means the company is generating more margin per unit of sell in that case it will acheive its break even sell in very small time.

Greater financial leverage lead to more interest cost which lead to higher value for accounting break even point for sell.

Ans 2) In numerator there is cash flow

In denominator there is required rate of return

Yes NPV can be negative if the required return is very high.

Negative NPV is no go because it will add negative value to the organisation which will lead to fall in price of stock of hte company in worst case it may default as well.

Ans 3) Starting the dividend tells that the company is not having any new opportunity to invest and at the same time it start generating enough free cash flwo to pay its shareholders, which is the positive sign.

Increasing the dividend is showing good sign that the business is making money.

Decreasing the dividend is bad sign it shows the compnay is facing some challenges.

Ans 4) Issusing more share as a negative sign because it shows that the company is financing its new project or in some cases its operation from financing activites which is not good for the shareholder because it will decrease the prie of share and shareholder will be having less say due to lesser percentage of the ownership.