Which of the following statements is most correct?
Click on the arrows to vote for the correct answer
A. B. C. D. E.C
Even in normal times, a firm should maintain a reserve borrowing capacity, which is the ability to borrow money at a reasonable cost when good investment opportunities arise.
Let's analyze each statement to determine which one is the most correct:
A. The statement suggests that the optimal capital structure, which refers to the mix of debt and equity financing, is the one that maximizes EBIT (earnings before interest and taxes). However, this statement also claims that the optimal capital structure always calls for a debt ratio lower than the one that maximizes expected EPS (earnings per share). This statement is incorrect. The optimal capital structure is not solely determined by maximizing EBIT or expected EPS. It depends on various factors such as the cost of capital, risk tolerance, and the company's specific circumstances.
B. This statement discusses the impact of financial leverage on the graphical probability distribution of net income. It suggests that when financial leverage is used (meaning when a company uses debt financing), the distribution of net income becomes more peaked compared to a situation without leverage, assuming all other factors remain constant. This statement is generally correct. Financial leverage can amplify the impact of both positive and negative changes in a company's operating income, leading to a more pronounced distribution of net income.
C. This statement relates to the goal of maintaining financial flexibility, which refers to a company's ability to access additional funding or credit when needed. It suggests that maintaining financial flexibility translates into maintaining adequate reserve borrowing capacity. This statement is generally correct. Maintaining borrowing capacity, such as having unused credit lines or maintaining a good credit rating, can provide a company with financial flexibility and the ability to respond to unexpected events or take advantage of opportunities.
D. The statement claims that business risk, which refers to the risk inherent in a company's operations, is constant for all firms within a particular industry. This statement is incorrect. Business risk can vary from one industry to another and can also differ among companies within the same industry. Industries with more stable demand patterns and lower competition may have lower business risk compared to industries with volatile demand and intense competition. Additionally, individual companies within an industry may have different risk profiles due to factors such as their market position, diversification, and management strategies.
E. The last option states that all of the statements provided are false. However, based on the analysis above, we can see that statement B is generally correct, and statement C is generally correct as well. Therefore, option E is not the correct answer.
In conclusion, the most correct statement among the given options is statement B, which explains the impact of financial leverage on the graphical probability distribution of net income.