0321286618_12 - Chapter 12 Leverage and Capital Structure...

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Chapter 12 Leverage and Capital Structure Instructor’s Resources Overview This chapter introduces the student to the concepts of operating and financial leverage and the associated business and financial risks. As a prerequisite to operating leverage, breakeven analysis is presented through graphic and algebraic methods. The limitations of breakeven analysis are also discussed. Financial leverage is presented graphically by comparing financial plans on a set of EBIT-EPS axes. The degree of operating, financial, and total leverage are presented to provide tools to measure the relative differences in risk of differing operating and financial structures within the firm. Capital structure is discussed with regard to a firm’s optimal mix of debt and equity, and the EBIT-EPS and valuation model approaches to evaluate capital structure, as well as important qualitative factors, are presented. Study Guide The following Study Guide examples are suggested for classroom presentation: Example Topic 1 Degree of operating leverage 4 Breakeven analysis Suggested Answer to Chapter Opening Critical Thinking Question What other factors may have led to the 2004 decline in the Krispy Kreme stock price? There were several other events in 2004 which probably had more to do with the decrease in Krispy Kreme stock than the low-carb diet phenomenon. One significant event was the sale of its existing Montana Mills operation. The sale resulted in a loss of $34.3 million or $0.54 per share. In July 2004, the Krispy Kreme disclosed an SEC informal inquiry related to the company’s franchise reacquisitions and the company’s previously announced reduction in earnings guidance. Any announcement of reduced expected earnings usually has a negative effect on a company’s stock price. Finally, Krispy Kreme sells doughnuts. Like any restaurant, many people like to try a new product when it first appears simply out of curiosity. Eventually, the novelty may wear off and the store has to work harder to maintain its customer base.
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46 Part 4 Long-Term Financial Decisions Answers to Review Questions 1. Leverage is the use of fixed-cost assets or funds to magnify the returns to owners. Leverage is closely related to the risk of being unable to meet operating and financial obligations when due. Operating leverage refers to the sensitivity of earnings before interest and taxes to changes in sales revenue. Financial leverage refers to the sensitivity of earnings available to common shareholders to changes in earnings before interest and taxes. Total leverage refers to the overall sensitivity of earnings available to common shareholders to changes in sales revenue. 2. The firm’s operating breakeven point is the level of sales at which all fixed and variable operating costs are covered; i.e., EBIT equals zero. An increase in fixed operating costs and variable operating costs will increase the operating breakeven point and vice versa. An increase in the selling price per unit will decrease the operating breakeven point and vice versa.
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