Question

Which of the following statements is correct?

a. increasing financial leverage is one way to increase a firm's return on invested capital.
b. if a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage.
c. the debt ratio that maximizes eps generally exceeds the debt ratio that maximizes share price.
d. if a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its return on invested capital. (assume that the repurchase has no impact on the company's operating income.)
e. if changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.

Answer 1

Lowering fixed costs while increasing variable costs, holding total costs constant, decreases a firm's operating leverage. This is because operating leverage is associated with the presence of fixed costs in a company's cost structure. The correct answer is option (b).

Step-by-step explanation:

When assessing the impacts of different financial decisions, the correct statement is (b) if a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. Operating leverage is defined by the proportion of fixed costs in a company's cost structure. The lower the fixed costs relative to variable costs, the lower the operating leverage.

In contrast, increasing financial leverage generally means using more debt, which can magnify returns but also increases risk. The debt ratio that maximizes EPS (earnings per share) may be higher than the debt ratio that maximizes share price because shareholders typically prefer a balance between risk and return. Issuing debt to repurchase stock affects the company's capital structure and may impact the return on equity, but since operating income is unaffected, the return on invested capital remains the same.

The complexity of financial decisions is evidenced by the various strategies a firm can deploy, such as issuing bonds or stock. The former commits the firm to interest payments, whereas the latter could mean relinquishing control but not being tied to scheduled payouts. Furthermore, venture capitalists provide an alternative by offering close managerial oversight and financial backing without the need for public offerings.

The correct answer is option (b).