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    Advantages of Debt, Debt Capital versus Equity

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    1. How is it possible to be solvent in the face of severe financial stress from illiquidity?

    2. While debt is viewed as bad by many people, in the context of the balance sheet, explain the advantageous reasons for using debt.

    3. What is the usual relationship between financial (debt) leverage and operating leverage? Why is this so?

    4. To the firm, the use of debt capital can be risky (debt versus equity), while for the investor, the opposite is the case. Why do you suppose this is the case?

    5. How does the movement toward variable interest rates affect the risk/reward relationship for the firm incurring debt and for the investor?

    6. In reference to common equity, in general, give the building blocks of the capital asset pricing model (CAPM), and point out some of the ambiguities (market portfolio, shape of yield curve, risk-free investment).

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    Solution Summary

    The advantages of debt and debt capital versus equity is examined.