Principles of Managerial Finance

(Dana P.) #1

508 PART 4 Long-Term Financial Decisions


capital structure
The mix of long-term debt and
equity maintained by the firm.


TABLE 12.1 General Income Statement Format and Types
of Leverage
Sales revenue
Less:Costofgoodssold
Operating leverage Gross profits
Less:Operatingexpenses
Earnings before interest and taxes (EBIT)
Less:Interest
Net profits before taxes Total leverage
Less:Taxes
Financial leverage Net profits after taxes
Less:Preferredstockdividends
Earnings available for common stockholders

Earnings per share (EPS)

LG1 LG2

leverage
Results from the use of fixed-cost
assets or funds to magnify
returns to the firm’s owners.


12.1 Leverage


Leverageresults 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 12.1.


  • Operating leverageis concerned with the relationship between the firm’s
    sales revenue and its earnings before interest and taxes, or EBIT. (EBIT is a
    descriptive label for operating profits.)

  • Financial leverageis concerned with the relationship between the firm’s EBIT
    and its common stock earnings per share (EPS).

  • Total leverageis concerned with the relationship between the firm’s sales rev-
    enue and EPS.


We will examine the three types of leverage concepts in detail in sections that
follow. First, though, we will look at breakeven analysis, which lays the founda-
tion for leverage concepts by demonstrating the effects of fixed costs on the firm’s
operations.
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