Concepts Review and Critical Thinking Questions

1. Business Risk versus Financial Risk Explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain.

2. M&M Propositions How would you answer in the following debate?

Q: Isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing?

A: Yes, that's the essence of M&M Proposition II.

Q: And isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firm's debt?

Q: In other words, increased borrowing increases the risk of the equity and the debt?

Q: Well, given that the firm uses only debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

© The McGraw-Hill Companies, 2002

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