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Unformatted text preview: VALUE
The amount of leverage (fixed-cost assets or funds) employed by a firm directly affects its
risk, return, and share value. Generally, higher leverage raises, and lower leverage reduces,
risk and return. Operating leverage is concerned with the level of fixed operating costs;
financial leverage focuses on fixed financial costs, particularly interest on debt and any preferred stock dividends. The firm’s financial leverage is determined by its capital structure—
its mix of long-term debt and equity financing. Because of its fixed interest payments, the
more debt a firm employs relative to its equity, the greater its financial leverage. The value
of the firm is clearly affected by its degree of operating leverage and by the composition of
its capital structure. The financial manager must therefore carefully consider the types of
operating and financial costs it incurs, recognizing that with greater fixed costs comes
higher risk. Major decisions with regard to both operating cost structure and capital structure must therefore focus on their impact on the firm’s value. Only those leverage and capital structure decisions that a...
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