Financial Reporting, Financial Statement Analysis and Valuation
8th Edition
ISBN: 9781285190907
Author: James M. Wahlen, Stephen P. Baginski, Mark Bradshaw
Publisher: Cengage Learning
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4.7 Disadvantages of Financial Leverage. The intuition behind the benefits of financial leverage is that a firm can borrow funds that bear a certain interest rate but invest those funds in assets that generate returns in excess of that rate. Why would firms with high ROAs not keep leveraging up their firm by borrowing and investing the funds in profitable assets?
Which of the following statements is correct?
A firm has a greater likelihood of needing an unexpected loan when its
cash flows are relatively constant over time.
The cost of borrowing affects the target cash balance of a firm.
Management's desire to maintain a low cash balance has no effect on
the borrowing needs of a firm.
The target cash balance increases as the interest rate rises.
The target cash balance decreases as the order costs increase.
Why use short-term financing?
Cash flows from operations may not be sufficient for a firm to keep up with growth-related financing needs, or the firm may not be able to always generate enough cash flow to maintain a surplus of cash. Firms prefer to borrow now to fulfill their capital requirements through means of short-term financing or long-term financing. Both methods have their advantages and disadvantages.
The following statement identifies a possible characteristic of short-term financing.
A. Consider this case:
Short-term credit agreements are more restrictive than long-term credit agreements.
Identify whether the preceding statement is true or false.
This statement is false.
This statement is true.
B. Firms use a variety of short-term financing sources to support working capital. Use the descriptions in the following table to identify the short-term financing source.
Description
Short-Term Financing Source
Continually recurring…
Chapter 4 Solutions
Financial Reporting, Financial Statement Analysis and Valuation
Ch. 4 - Common-Size Analysis. Common-size analysis is a...Ch. 4 - Earnings per Share. Firm A reports an increase in...Ch. 4 - Prob. 3QECh. 4 - Profit Margin for ROA versus ROCE. Describe the...Ch. 4 - Concept and Measurement of Financial Leverage....Ch. 4 - Advantages of Financial Leverage. A company...Ch. 4 - Prob. 7QECh. 4 - Nucor, a steel manufacturer, reported net income...Ch. 4 - Phillips-Van Heusen, an apparel manufacturer,...Ch. 4 - TJX, Inc., an apparel retailer, reported net...
Ch. 4 - Boston Scientific, a medical device manufacturer,...Ch. 4 - Valero Energy, a petroleum company, reported net...Ch. 4 - Exhibit 4.22 presents selected operating data for...Ch. 4 - Microsoft Corporation (Microsoft) and Oracle...Ch. 4 - Prob. 17PCCh. 4 - Prob. 18PCCh. 4 - Texas Instruments (TI) designs and manufactures...Ch. 4 - JCPenney operates a chain of retail department...Ch. 4 - Prob. 21PCCh. 4 - Selected data for General Mills for 2007, 2008,...Ch. 4 - Prob. 23PCCh. 4 - Hasbro is a leading firm in the toy, game, and...Ch. 4 - Fitch sells casual apparel and personal care...Ch. 4 - Prob. 26PCCh. 4 - Starwood Hotels (Starwood) owns and operates many...Ch. 4 - Select data for Avis and Hertz for 2012 follow....Ch. 4 - Integrative Case 1.1 introduced the industry...Ch. 4 - Prob. 1ABICCh. 4 - Prob. 1ACICCh. 4 - Prob. 1BAICCh. 4 - Prob. 1BBICCh. 4 - Walmart and Carrefour follow similar strategies....Ch. 4 - Walmart and Carrefour follow similar strategies....
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- Many businesses finance their investment activities internally. Should internal financing affect the efficiency with which the interest rate performs its functions? No, investment is profitable if the expected rate of return is greater than the rate of interest regardless of the source of funds. Yes, investment is profitable if the expected rate of return is greater than the rate of interest regardless of the source of funds. O No, because internal financing relies on a different profit calculation. Yes, because firms are usually more anxious about what happens to money that they do not have to pay back.arrow_forwardSeveral factors affect a firm’s need for external funds. Evaluate the effect of each following factor and place a check next to each factor that is likely to increase a firm’s need for external capital—that is, its AFN (additional funds needed). Check all that apply. The firm increases its dividend payout ratio. The firm switches its supplier for the majority of its raw materials. The new supplier offers less favorable credit terms and thus reduces the trade credit available to the firm, resulting in a reduction in accounts payable. The firm improves its production system and increases its profit margin. Accounts payable and accrued liabilities represent obligations that the firm must pay off. Assuming everything else holds constant, if they increase, the firm’s AFN will_________ .arrow_forwardCompanies that face large investments they cannot finance internally through the retention of earnings must go to the financial market to raise the needed funds. When they do this, they will incur what are commonly referred to as floatation costs. Discuss how these floatation costs should be incorporated into the firm’s analysis of net present valuearrow_forward
- What is the purpose of financial leverage in finance? a) To increase the company's liquidity b) To reduce the company's risk c) To increase the company's profitability d) To magnify the company's returns and risksarrow_forwardWhich of the following statement are true? Direct transfer of capital involves the aid of investment banks and intermediaries None of the statements are correct Interest rates are likely to decrease when there is an expected increase in inflation Interest rates are likely to grow when companies have declining productive opportunitiesarrow_forwardExplain how capital adequacy requirements may affect a commercial bank’s dividend payout and growth potential. If the bank anticipates a decrease in its capital adequacy ratio (capital to total asset ratio), what options are available to prevent the decline? What risks, if any, are there in each strategy... Banks’ managers do not want to mmaintain much capital because they do not bear fully the costs of their failure. In addition to this reason others claim that banks’ managers do not want to maintain higher levels of capital because higher levels of capital attract greater scrutiny from bank regulators. Comment on this claim. The two most pressing demands for liquidity from a bank come from, first, customers withdrawing their deposits. Identify and discuss the second demand on the bank for liquidity.arrow_forward
- Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds. A) Which of the following is considered a financially leveraged firm? A company that uses debt to finance some of its assets A company that uses only equity to finance its assets B) Which of the following is true about the leveraging effect? Under economic growth conditions, firms with relatively more leverage will have higher expected returns. Under economic growth conditions, firms with relatively low leverage will have higher expected returns. C) Blue Sky Drone Company has a total asset turnover ratio of 8.50x, net annual sales of $40 million, and operating expenses of $18 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 7%…arrow_forwardThe market for capital Firms require capital to invest in productive opportunities. The best firms with the most profitable opportunities can attract capital away from inefficient firms with less profitable opportunities. Investors supply firms with capital at a cost called the interest rate. The interest rate that investors require is determined by several factors, including the availability of production opportunities, the time preference for current consumption, risk, and inflation. Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate. Q1. Which tend to be more volatile, short- or long-term interest rates? Long-term interest rates 2. Short-term interest rates Q2. If the inflation rate was 3.20% and the nominal interest rate was 4.20% over the last year, what was the real rate of interest over…arrow_forward2. If the value of the financial sector is in terms of reducing the individual risk in the economy, how could you measure the value of the financial sector without using information on loan payments (broadly construed to include any interest payment necessary to measure an interest rate or any payment that looks like a return on an investmemt)? If we think of the amount of individual risk remaining after individuals buy portfolios is a measure of the ineffectiveness of the financial sector [or its imperfections], what do you think accounts for these imperfections?arrow_forward
- Cash flows from operations may not be sufficient for a firm to keep up with growth-related financing needs, or the firm may not be able to always generate enough cash flow to maintain a surplus of cash. Firms prefer to borrow now to fulfill their capital requirements through means of short-term financing or long-term financing. Both methods have their advantages and disadvantages. The following statement identifies a possible characteristic of short-term financing. Consider this case: Short-term loans usually have a lower cost than long-term loans. Identify whether the preceding statement is true or false. This statement is true and an advantage of short-term financing. This statement is false and a disadvantage of short-term financing. Firms use a variety of short-term financing sources to support working capital. Use the descriptions in the following table to identify the short-term financing source. Description Short-Term Financing Source…arrow_forwardSee below for some statements on how financial managers can create value for their firms. Which of the following statement(s) is (are) TRUE? Select one or more alternatives: If capital markets are inefficient at times, financial managers could create value through financing decisions. Capital markets are less efficient than goods markets; this is why the primary source of creating value is through clever financing decisions. Managers can create value for a firm's stakeholders through improving its ESG performance. The "ESG" in ESG investing stands for environmental, social and governance. Managers can create value for a firm's stakeholders through improving its ESG performance. The "ESG" in ESG investing stands for environmental, sustainability and governance.arrow_forwardIn a few sentences, answer the following question as completely as you can. Why should financial decision makers obtain a good estimate of a firm’s cost of capital? What are the consequences of using a discount rate that is higher or lower than a firm’s true required return?arrow_forward
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