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

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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. LG6 LG5 LG4 LG3 LG2 LG1 421
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422 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.
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