Principles of Managerial Finance

516 PART 4 Long-Term Financial Decisions

8. As noted in Chapter 7, although preferred stock dividends can be “passed” (not paid) at the option of the firm’s
   directors, it is generally believed that payment of such dividends is necessary. This text treats the preferred stock div-
   idend as a contractual obligation, not only to be paid as a fixed amount, but also to be paid as scheduled.Although
   failure to pay preferred dividends cannot force the firm into bankruptcy, it increases the common stockholders’ risk
   because they cannot be paid dividends until the claims of preferred stockholders are satisfied.

TABLE 12.5 Operating Leverage and Increased Fixed

Costs

Case 2 Case 1

50% 50%

Sales (in units) 500 1,000 1,500

Sales revenuea $5,000 $10,000 $15,000

Less: Variable operating costsb 2,250 4,500 6,750

Less: Fixed operating costs  (^3) , (^0)  (^0)  (^0)   (^3) , (^0)  (^0)  (^0)   (^3) , (^0)  (^0)  (^0) 
Earnings before interest and taxes (EBIT) $ 250 $ 2,500 $ 5,250
110% 110%
aSales revenue was calculated as indicated in Table 12.4.
bVariable operating costs$4.50/unitsales in units.
financial leverage
The potential use of fixed
financial coststo magnify the
effects of changes in earnings
before interest and taxes on the
firm’s earnings per share.
Comparing this value to the DOL of 2.0 before the shift to more fixed costs
makes it is clear that the higher the firm’s fixed operating costs relative to vari-
able operating costs, the greater the degree of operating leverage.
Financial Leverage
Financial leverage results from the presence offixed financial costsin the firm’s
income stream. Using the framework in Table 12.1, we can definefinancial
leverageas the potential use offixed financial coststo 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
EXAMPLE Chen Foods, a small Oriental food company, expects EBIT of $10,000 in the cur-
rent 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 outstand-
ing. 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 pre-
ferred stock are $2,400 ($4.00/share600 shares). Table 12.6 presents the EPS
corresponding to levels of EBIT of $6,000, $10,000, and $14,000, assuming that
the firm is in the 40% tax bracket. Two situations are shown: