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Firm Value and Financial Leverage

1) Firm value is calculated by adding expected cash flow to the firm's cost of capital under each capital structure. True or False.

2) The degree of financial leverage measures the sensitivity of_______ to changes in ________.

a) net sale, EBIT. b) EBIT, net sales c) EBIT, EPS. d) EPS,EBIT.

3) Explain how diversification affects risk and how correlation between securities affects portfolio risk.

Solution Preview

1. False. Firm valuation is done by discounting expected cash flows to the firm at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. Thus cash flow is divided by the cost of capital, not added to it.

2. b. The response of earnings before income tax to net sales determines the degree of financial leverage. The greater the operating leverage, the more EBIT will change in response to a change in sales.

3. Each type of investment carries a different type of risk. Exposure to overseas stocks exposes the investor to exchange rate risks, for example. Investing at home carries the risk ...