Practical Difficulties

A

Two projects being considered are mutually exclusive and have the following projected cash flows:

Year Project AProject B -

0-$50,000-$50,000

115,6250

215,6250

315,6250

415,6250

515,62599,500

The correct answer is A. All of these statements are correct.

The practical difficulties associated with capital structure and degree of leverage analyses are outlined in the provided answer choices. Let's break down each statement and provide a detailed explanation for each one:

A. All of these statements are correct. This statement acknowledges that all the following statements in options C, D, and E are valid difficulties associated with capital structure and degree of leverage analyses.

C. Managers' attitudes toward risk differ, and some managers may set a target capital structure other than the one that would maximize stock price. This statement highlights the subjective nature of managerial decision-making when it comes to determining the capital structure of a company. Managers have different risk preferences, and they may prioritize factors other than maximizing stock price when setting a target capital structure. For example, a manager may choose a capital structure that emphasizes financial stability or debt repayment over maximizing stock price. These differing attitudes toward risk can make it challenging to achieve an optimal capital structure.

D. Managers often have a responsibility to provide continuous service; they must preserve the long-run viability of the enterprise. Thus, the goal of employing leverage to maximize short-run stock price and minimize capital cost may conflict with long-run viability. This statement recognizes that managers must consider the long-term viability and sustainability of the company. While employing leverage (using debt) to maximize short-term stock price and minimize capital costs may seem attractive, it can potentially undermine the long-term stability of the enterprise. Excessive leverage can increase financial risk and potentially lead to financial distress or bankruptcy. Balancing short-term objectives with long-term viability is a complex challenge for managers.

E. It is nearly impossible to determine exactly how P/E ratios or equity capitalization rates are affected by different degrees of financial leverage. This statement highlights the difficulty of precisely determining the impact of different degrees of financial leverage on valuation metrics such as price-to-earnings (P/E) ratios or equity capitalization rates. Financial leverage can influence these metrics, but the exact relationship is complex and can vary based on industry, market conditions, and other factors. Therefore, it is challenging to accurately quantify the precise effect of leverage on these valuation measures.

In conclusion, the practical difficulties associated with capital structure and degree of leverage analyses include the differing risk attitudes of managers, the potential conflict between short-term stock price maximization and long-term viability, and the challenges in determining the precise impact of leverage on valuation metrics. Therefore, option A correctly states that all of these statements represent practical difficulties in the practical application of leverage analysis in capital structure determination.