Question

A company's capital structure consists of equity only. What is its degree of leverage?

• A. High leverage
• B. Low leverage
• C. Medium leverage
• D. No leverage

Answer 1

Answer:

D. No leverage

• Capital Structure Definition: Capital structure refers to the specific mix of debt and equity used to finance a company's assets and operations.
• Leverage Concept: Financial leverage, often called trading on equity, occurs when a company uses borrowed funds (debt) to finance the purchase of assets, with the expectation that the income or capital gain generated will exceed the cost of borrowing.
• Equity-Only Financing: When a company is financed entirely through equity (shareholders' funds), it does not carry any debt obligations such as loans, debentures, or bonds.
• Impact on Leverage: Because leverage is strictly a measure of debt relative to equity, a firm with 100% equity has zero debt in its capital structure. Consequently, the Degree of Financial Leverage (DFL) is 1.0, and the company is considered to have no leverage or be unlevered.
• Risk Implications: Unlevered firms face no interest payment obligations, which eliminates the risk of financial distress or bankruptcy resulting from an inability to meet debt service requirements.
• Key Formulas: Financial leverage is often measured by the debt-to-equity ratio. If total debt is zero, the ratio is 0. Similarly, in the formula for DFL = EBIT / (EBIT - Interest), if Interest is zero, DFL equals 1, indicating no amplification of earnings per share (EPS) through debt financing.