Lecture 4

Question 1

Formula for APR (annual percentage rate)

Answer 1

APR = (1+r)^12 - 1
R = monthly interest rate as decimal

Question 2

Capital gearing ratio

Answer 2

Debt/equity =
Gearing ratio = debt / equity

Debt to total capital =
Debt / (debt + equity)

Question 3

Interest cover ratio

Answer 3

Interest cover = EBIT / interest expense
EBIT = earnings before tax and interest

Question 4

What does a high interest cover ratio indicate?

Answer 4

Greater ability to pay interest, lower financial risk

Question 5

What’s the risk of using simple interest for APR calculation?

Answer 5

It under estimates true annual cost, compound interest must be used

Question 6

Why is debt financing considered cheaper than equity?

Answer 6

Interest payments, tax deductible and lower risk to investors

Question 7

What’s the key disadvantage of high gearing ratio?

Answer 7

Increased risk of insolvency due to fixed repayment obligations

Question 8

What does a gearing ratio of above 50% typically indicate?

Answer 8

High financial leverage and potential vulnerability

Question 9

What are debt covenants and why are they important?

Answer 9

Legal restrictions from lenders to limit borrow risk