CHAPTER 12 Leverage and Capital Structure 543SUMMARY
FOCUS ON VALUE
The amount of leverage (fixed-cost assets or funds) employed by a firm directly affects its
risk, return, and share value. Generally, higher leverage raises, and lower leverage reduces,
risk and return. Operating leverage is concerned with the level of fixed operating costs;
financial leverage focuses on fixed financial costs, particularly interest on debt and any pre-
ferred stock dividends. The firm’s financial leverage is determined by its capital structure—
its mix of long-term debt and equity financing. Because of its fixed interest payments, the
more debt a firm employs relative to its equity, the greater its financial leverage. The value
of the firm is clearly affected by its degree of operating leverage and by the composition of
its capital structure. The financial manager must therefore carefully consider the types of
operating and financial costs it incurs, recognizing that with greater fixed costs comes
higher risk. Major decisions with regard to both operating cost structure and capital struc-
ture must therefore focus on their impact on the firm’s value. Only those leverage and capi-
tal structure decisions that are consistent with the firm’s goal of maximizing its stock price
should be implemented.REVIEW OF LEARNING GOALS
Discuss the role of breakeven analysis, the oper-
ating breakeven point, and the effect of chang-
ing costs on it.Breakeven analysis measures the
level of sales necessary to cover total operating
costs. The operating breakeven point may be calcu-
lated algebraically, by dividing fixed operating costs
by the difference between the sale price per unit and
variable operating cost per unit, or it may be deter-
mined graphically. The operating breakeven point
increases with increased fixed and variable operat-
ing costs and decreases with an increase in sale
price, and vice versa.
Understand operating, financial, and total
leverage and the relationships among them.
Operating leverage is the use of fixed operating
costs by the firm to magnify the effects of changes
in sales on EBIT. The higher the fixed operating
costs, the greater the operating leverage. Financial
leverage is the use of fixed financial costs by the
firm to magnify the effects of changes in EBIT on
EPS. The higher the fixed financial costs—typically,
interest on debt and preferred stock dividends—the
LG2LG1 greater the financial leverage. The total leverage of
the firm is the use of fixed costs—both operating
and financial—to magnify the effects of changes in
sales on EPS. Total leverage reflects the combined
effect of operating and financial leverage.Describe the types of capital, external assess-
ment of capital structure, the capital structure
of non-U.S. firms, and capital structure theory. Two
basic types of capital—debt capital and equity capi-
tal—make up a firm’s capital structure. They differ
with respect to voice in management, claims on in-
come and assets, maturity, and tax treatment. Capi-
tal structure can be externally assessed by using fi-
nancial ratios—debt ratio, times interest earned
ratio, and fixed-payment coverage ratio. Non-U.S.
companies tend to have much higher degrees of in-
debtedness than do their U.S. counterparts, primar-
ily because U.S. capital markets are much more de-
veloped. Similarities between U.S. corporations and
those of other countries include industry patterns of
capital structure, large multinational company capi-
tal structures, and the trend toward greater relianceLG3