Chapter15 - 15-1CHAPTER 15Leverage and the Debt-Equity...

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Unformatted text preview: 15-1CHAPTER 15Leverage and the Debt-Equity MixQUESTIONS1.In what way is business leverage similar to physical leverage?Both types of leverage involve magnification. In both, we carefully construct our system to produce the magnified result. The differences are in what is magnifiedincome vs. physical force, and what serves as the leverfixed costs vs. a mechanical device.2.Distinguish between operating leverage and financial leverage.Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company's cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statementhow EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statementhow earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.3.How much choice does a firm have over its operating leverage? Over its financial leverage?Choice over operating leverage depends on the technologies available to a company. Some companies have little control over their operating leverage. For example, airlineswhich have no substitute for airplanes and their associated support systemscan only operate with a large investment in fixed assets that create fixed costs. Other companies have a significant degree of control over their operating leverage. Many manufacturing companies, for example, can choose to produce using automated equipment or piecework labor. By contrast, most firms have total control over their financial leverage through their choice of financing (the exception is small firms that have limited access to financial markets, hence limited financing alternatives). A company can increase its financial leverage by using debt financing and can avoid financial leverage through financing with equity.4.Describe the way in which earnings per share responds to changing EBIT in a firm with:a. No fixed financing costs.A firm with no fixed financing costs has no financial leverage. In such a firm, earnings per share will rise and fall with EBIT by the same percentage. For example, a 15% increase in EBIT will result in a 15% increase in EPS; a 9% decrease in EBIT will result in a 9% decrease in EPS.15-2Chapter 15b. Some fixed financing costs.A firm with some fixed financing costs does have financial leverage. In such a firm, earnings per share will rise and fall with EBIT by a greater percentage. For example, a 15% increase in EBIT will result in a more-than-15% increase in EPS; a 9% decrease in EBIT will result in a more-than-9% decrease in EPS....
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Chapter15 - 15-1CHAPTER 15Leverage and the Debt-Equity...

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