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Answer the following questions:
a) Explain what is meant by “business risk” and “financial risk”. b) Assume that Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Explain. c) Why is the use of debt financing referred to as using financial “leverage”? What is “homemade leverage”? Explain. d) Describe the “trade-off” that defines the static theory of capital structure. e) You are considering a firm under three separate scenarios: (1) no debt, no taxes, and no bankruptcy costs; (2) with debt and with taxes but no bankruptcy costs; and (3) with debt, with taxes, and with bankruptcy costs. Under which one of these three scenarios will the firm have the highest value? Explain your answer. [20 marks]
2) Gabella`s is an all-equity firm that has 21,000 shares of stock outstanding at a market price of $40 a share. The firm has earnings before interest and taxes of $84,000 and has a 100 percent dividend payout ratio. Ignore taxes. Gabella`s has decided to issue $160,000 of debt at a rate of 12 percent and use the proceeds to repurchase shares. Terry owns 400 shares of Gabella`s stock and has decided to continue holding those shares.
Using the information provided, you are required to answer the following questions:
a) What is Gabella`s earnings per share before its debt issue? Show your calculations. b) What is Terry`s total annual dividend income before Gabella`s debt issue? Show your calculations. c) What is Gabella`s earnings per share after its debt issue? Show your calculations. d) How will Gabella`s debt issue affect Terry`s total annual dividend income? Show your calculations.
