Principles of Managerial Finance

CHAPTER 12 Leverage and Capital Structure 521

13. Of course, although capital structure is financially important, it, like many business decisions, is generally not so
    important as the firm’s products or services. In a practical sense, a firm can probably more readily increase its value
    by improving quality and reducing costs than by fine-tuning its capital structure.

LG3 LG4

EXAMPLE Substituting the values calculated for DOL and DFL, shown on the right-hand

side of Table 12.7, into Equation 12.10 yields

DTL1.25.06.0

The resulting degree of total leverage is the same value that we calculated directly

in the preceding examples.

Review Questions

12–1 What is meant by the term leverage?How are operating leverage, financial

leverage, and total leverage related to the income statement?

12–2 What is the operating breakeven point?How do changes in fixed operat-

ing costs, the sale price per unit, and the variable operating cost per unit

affect it?

12–3 What is operating leverage?What causes it? How is the degree of operat-

ing leverage (DOL)measured?

12–4 What is financial leverage?What causes it? How is the degree of financial

leverage (DFL)measured?

12–5 What is the general relationship among operating leverage, financial lever-

age, and the total leverage of the firm? Do these types of leverage comple-

ment each other? Why or why not?

12.2 The Firm’s Capital Structure

Capital structure is one of the most complex areas of financial decision making

because of its interrelationship with other financial decision variables.^13 Poor

capital structure decisions can result in a high cost of capital, thereby lowering

the NPVs of projects and making more of them unacceptable. Effective capital

structure decisions can lower the cost of capital, resulting in higher NPVs and

more acceptable projects—and thereby increasing the value of the firm. This sec-

tion links together many of the concepts presented in Chapters 4, 5, 6, 7, and 11

and the discussion of leverage in this chapter.

Types of Capital

All of the items on the right-hand side of the firm’s balance sheet, excluding cur-

rent liabilities, are sources of capital. The following simplified balance sheet illus-

trates the basic breakdown of total capital into its two components, debt capital

and equity capital.