chapter11 - Chapter Across the Disciplines 11 Why This...

Leverage
and Capital
Structure
Chapter
Across the Disciplines
Why This Chapter Matters To You
Accounting: You need to understand
how to calculate and analyze operating
and financial leverage and to be familiar
with the tax effects of various capital
structures.
Information systems: You need to under-
stand the types of capital and what capital
structure is, because you will provide
much of the information needed in man-
agement’s determination of the best capi-
tal structure for the firm.
Management: You need to understand
leverage so that you can magnify returns
for the firm’s owners and to understand
capital structure theory so that you can
make decisions about the firm’s optimal
capital structure.
Marketing: You need to understand
breakeven analysis, which you will use in
pricing and product feasibility decisions.
Operations: You need to understand the
impact of fixed and variable operating
costs on the firm’s breakeven point and its
operating leverage, because these costs
will have a major impact on the firm’s risk
and return.
11
LEARNING GOALS
Discuss the role of breakeven
analysis, the operating breakeven
point, and the effect of changing
costs on it.
Understand operating, financial, and
total leverage and the relationships
among them.
Describe the types of capital, external
assessment of capital structure, the
capital structure of non-U.S. firms,
and capital structure theory.
Explain the optimal capital structure
using a graphical view of the firm’s
cost-of-capital functions and a zero-
growth valuation model.
Discuss the EBIT–EPS approach to
capital structure.
Review the return and risk of
alternative capital structures, their
linkage to market value, and other
important considerations related to
capital structure.
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LG5
LG4
LG3
LG2
LG1
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PART 4 Long-Term Financial Decisions
capital structure
The mix of long-term debt and
equity maintained by the firm.
leverage
Results from the use of fixed-cost
assets or funds to magnify
returns to the firm’s owners.
Leverage
Leverage results from the use of fixed-cost assets or funds to magnify returns to
the firm’s owners. Generally, increases in leverage result in increased return and
risk, whereas decreases in leverage result in decreased return and risk. The
amount of leverage in the firm’s capital structure —the mix of long-term debt and
equity maintained by the firm—can significantly affect its value by affecting
return and risk. Unlike some causes of risk, management has almost complete
control over the risk introduced through the use of leverage. Because of its effect
on value, the financial manager must understand how to measure and evaluate
leverage, particularly when making capital structure decisions.
The three basic types of leverage can best be defined with reference to the firm’s
income statement, as shown in the general income statement format in Table 11.1.