Chapter 15 IM 10th Ed - CHAPTER 15 Analysis and Impact of...

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                                                                                                                                                                                                                CHAPTER 15 Analysis and Impact of Leverage                                                                                                                                                                                                                 CHAPTER ORIENTATION This chapter focuses on useful aids for the financial manager in determining the firm's proper financial structure. It includes the definitions of the different kinds of risk, a review of   breakeven   analysis,   the   concepts   of   operating   leverage,   financial   leverage,   the combination of both leverages, and their effect on EPS (earnings per share). CHAPTER OUTLINE I. Business risk and financial risk A. Risk is defined as the likely variability associated with expected revenue streams. 1. The variations in the income stream can be attributed to a. The firm's exposure to business risk b. The firm's decision to incur financial risk B. Business risk is defined as the variability of the firm's expected earnings before interest and taxes. 1. Business risk is measured by the firm's corresponding expected coefficient of variation. 2. Dispersion in operating income does not cause business risk. It is the result of several influences, such as the company’s cost structure, product demand characteristics, and intra-industry competition. C. Financial risk is a direct result of the firm's financing decision. It refers to the additional variability in earnings available to the firm’s common stockholders and the additional chance of insolvency borne by the common shareholder when financial leverage is used. 98
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1. Financial leverage is the financing of a portion of the firm's assets with securities bearing a fixed rate of return in hopes of increasing the return to the common shareholders. 2. Financial risk is passed on to the common shareholders who must bear most of the inconsistencies of returns to the firm after the deduction of fixed payments. II. Break-even Analysis A. The objective of break-even analysis is to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit.
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