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Unformatted text preview: he presence of fixed financial costs in the firm’s
income stream. Using the framework in Table 12.1, we can define financial
leverage as the potential use of fixed financial costs to magnify the effects of
changes in earnings before interest and taxes on the firm’s earnings per share.
The two fixed financial costs that may be found on the firm’s income statement
are (1) interest on debt and (2) preferred stock dividends. These charges must be
paid regardless of the amount of EBIT available to pay them.8
Chen Foods, a small Oriental food company, expects EBIT of $10,000 in the current year. It has a $20,000 bond with a 10% (annual) coupon rate of interest and
an issue of 600 shares of $4 (annual dividend per share) preferred stock outstanding. It also has 1,000 shares of common stock outstanding. The annual interest
on the bond issue is $2,000 (0.10 $20,000). The annual dividends on the preferred stock are $2,400 ($4.00/share 600 shares). Table 12.6 presents the EPS
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