Question

Company X has a higher degree of financial risk than Company Y. Company X can offset this by lowering its operating leverage. True or false? Firm A has more business risk than Firm B, but they both have the same total risk. Which of the following statements must be true? a. In order to offset its higher business risk, Firm A will increase its operating leverage so that its total risk is the same as Firm B's. b. Because Firm A has more business risk than Firm B, its debt ratio will be greater than Firm B's. c. Because Firm B has less business risk than Firm A, its debt ratio will be lower than Firm A's. d. None of the statements above are true. The correct response is .

Answer 1

1. True
2. d. None of the statements above are true.

Step-by-step explanation:

1. Financial risk refers to the risk of defaulting on debt obligations by a company. Company X can indeed offset this by lowering its operating leverage because a high operating level means that the company's cashflows are more unpredictable which means there is uncertainty and uncertainty is risky.

If the Operating Leverage is lowered, there is less risk.

2. Option A is wrong because if Firm A increases their operating leverage its risk will become even higher therefore making its total risk higher than Firm B.

Option B is wrong because the debt ratio relates to financial risk not business risk. Option C is wrong for the same reason.

None of the statements are therefore true.