Answer to Question #6765 in Economics of Enterprise for LaMarcus Streeter

Question

5. Which of the following statements is CORRECT?

a. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
c. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
d. Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes.
e. Since most stocks sell at or very close to their book values, book value capital structures are almost always adequate for use in estimating firms' costs of capital.

Answer 1

The Statement D is CORRECT. Wide variations in the use of financial leverage
occur both across industries and among individual firms within given industries.
These differences are caused by differing business risks and also managerial
attitudes. Drug and biotechnology companies don't use much debt (their common
equity ratios are high). The uncertainties inherent in industries that are
cyclical, oriented toward research or subject to huge product liability suits
normally render the heavy use of debt unwise. On the other hand, utilities
traditionally have used large amounts of debt, particularly long-term debt.
Their fixed assets make good security for mortgage bonds, and their relatively
stable sales make it safe for them to carry more debt than would be true for
firms with more business risks.