14 Chapter model
Capital Structure and Leverage
A's breakeven units = 40,000.
Plan A: Low Fixed, High Varia
Data Applicable to Both Plans
Standard Deviation (SD):
Coefficient of Variation (CV):
The results generated above are graphed here:
In this chapter, we introduce two new dimensions of risk, business risk and financial risk.
is the risk inherent in the firm's operations, and it would be there even if the firm used no deb
risk is the additional risk borne by the stockholders as a result of the use of debt.
BUSINESS RISK AND OPERATING LEVERAGE
Operating leverage reflects the degree to which fixed costs are embedded in a firm's operatio
a high percentage of a firm's costs are fixed, then the firm is said to have high operating leve
these costs are incurred even if sales decline.
High operating leverage produces a situation
small change in sales can result in a large change in operating income.
The following examp
two operational plans with different degrees of operating leverage.
Using the input data giv
examine the firm's profitability under two operating plans, in different states of the economy
Which plan is better?
Based on expected profits and ROE, Plan B looks better.
riskier, as measured by the standard deviation (SD) and the coefficient of variation (CV).
tradeoff between risk and return--B is more profitable, but A is less risky.
Someone will have
between the two plans, but at this point we have no basis for making the choice.
Note also that Plan A will break even at sales as low as 40,000 units, while Plan B would hav
loss at that level.
B's breakeven point is 50% higher, at 60,000 units.