Chapter 15 IM 10th Ed

Chapter 15 IM 10th - CHAPTER 15 Analysis and Impact of Leverage CHAPTER ORIENTATION This chapter focuses on useful aids for the financial manager

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Unformatted text preview: 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. 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. 98 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 by studying the relationships among the firm’s cost structure, volume of output, and operating profit. 1. The break-even 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 3. Labor contract negotiations 4. Evaluation of cost structure 5. Financial decisions making D. Essential elements of the break-even model 1. Production costs must be separated into fixed costs and variable costs. 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 99 3.3....
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This note was uploaded on 07/29/2011 for the course FIN 202 taught by Professor Hung during the Spring '11 term at Keuka.

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Chapter 15 IM 10th - CHAPTER 15 Analysis and Impact of Leverage CHAPTER ORIENTATION This chapter focuses on useful aids for the financial manager

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