Chapter 13 Capital Structure and Leverage 429SELF^ TEST Why do wide variations in the use of! nancial leverage occur across indus-
tries and among individual! rms in each industry?When we studied the cost of capital in Chapter 10, we took the! rm’s capital structure
as given and calculated the cost of capital based on that structure. Then in Chapters
11 and 12, we described capital budgeting techniques, which use the cost of capital
as input. Capital budgeting decisions determine the types of projects that a! rm ac-
cepts, which a" ect the nature of the! rm’s assets and its business risk. In this chapter,
we reverse the process, taking the! rm’s assets and business risk as given and then
seeking to determine the best way to! nance those assets. More speci! cally, in this
chapter, we examined the e" ects of! nancial leverage on earnings per share, stock
prices, and the cost of capital and we discussed various capital structure theories.
The di" erent theories lead to di" erent conclusions about the optimal capital
structure, and no one has been able to prove that one theory is better than the oth-
ers. Therefore, we cannot estimate the optimal capital structure with much precision.
Accordingly,! nancial executives generally treat the optimal capital structure as a
range—for example, 40% to 50% debt—rather than as a precise point, such as 45%.
The concepts discussed in this chapter are used as a guide, and they help managers
understand the factors to consider when they are setting their target capital
structures.
T Y I N G I T A L L T O G E T H E R
KEY TERMS Define each of the following terms:
a. Optimal capital structure; target capital structure
b. Business risk; financial risk
c. Financial leverage; operating leverage; operating breakeven
d. Hamada equation; unlevered beta
e. Symmetric information; asymmetric information
f. Modigliani-Miller theories
g. Trade-off theory; signaling theory
h. Reserve borrowing capacity
OPERATING LEVERAGE AND BREAK!EVEN ANALYSIS Olinde Electronics Inc. produces
stereo components that sell at P " $100 per unit. Olinde’s fixed costs are $200,000, variable
costs are $50 per unit, 5,000 components are produced and sold each year, EBIT is currently
$50,000, and Olinde’s assets (all equity financed) are $500,000. Olinde can change its
production process by adding $400,000 to assets and $50,000 to fixed operating costs. This
change would (1) reduce variable costs per unit by $10 and (2) increase output by 2,000 units,