imchap13 - 13-1 CHAPTER 13 Analysis and Impact of Leverage...

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Unformatted text preview: 13-1 CHAPTER 13 Analysis and Impact of Leverage CHAPTER ORIENTATION This chapter focuses on useful aids to the financial manager in his or her determination of the firm's proper financial structure. 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 13-2 2. Dispersion in operating income does not cause business risk. It is the result of several influences. C. Financial risk is a direct result of the firm's financing decision. It refers to the additional variability in earnings available to and the additional chance of insolvency borne by the common shareholder caused by the use of financial leverage. 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 almost all of the inconsistencies of returns to the firm after the deduction of fixed payments. D. Perspective on breakeven analysis II. Breakeven analysis A. Objective: To determine the breakeven quantity by studying the relationships among the cost structure, volume of output, and operating profit. 1. The breakeven quantity of output results in an EBIT level equal to zero. B. Use of the model enables the financial officer to 1. Determine the quantity of output that must be sold to cover all operating costs. 2. Calculate the EBIT achieved at various output levels. C. Some potential applications include 1. Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models 2. Pricing policy 13-3 3. Labor contract negotiations 4. Evaluation of cost structure 5. The making of financial decisions. D. Essential elements of the breakeven model 1. Production costs must be separated into fixed costs and variable costs. E. Assumed behavior of costs 1. Fixed costs do not vary as the sales volume or the quantity of output changes. Examples include a. Administrative salaries b. Depreciation c. Insurance premiums d Property taxes e. Rent 2. Variable costs vary in total as output changes. Variable costs are fixed per unit of output. Examples include a. Direct materials b. Direct labor c. Energy cost associated with production d. Packaging e. Freight-out f. Sales commissions 3. In order to implement the behavior of the breakeven model, it is necessary for the financial manager to a. Identify the most relevant output range for planning purposes....
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imchap13 - 13-1 CHAPTER 13 Analysis and Impact of Leverage...

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