Exam 12: Leverage and Capital Structure

Since the sales price per unit generally decreases with volume and the cost per unit generally increases with volume, the true breakeven point may be different from those obtained using linear revenue and cost functions as assumed in the breakeven analysis.

China America Manufacturing is evaluating two different operating structures which are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of 40 percent. (a) For each operating structure, calculate (a1) EBIT and EPS at 10,000, 20,000, and 30,000 units. (a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as a base sales level. (a3) the operating breakeven point in units. (b) Which operating structure has greater operating leverage and business risk? (c) If China America projects sales of 20,000 units, which operating structure is recommended?

Because of the extensive research conducted in recent years in the area of capital structure theory, it is now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure.

________ costs require the payment of a specified amount in each accounting period.

The firm's operating breakeven point is the point at which

Total leverage can be defined as the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm's earnings per share.

Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors.

Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are expected to remain at this level indefinitely. Stockholders currently require a 12.1 percent return on their investment. Nico is considering changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level indefinitely. However, because of the added risk, the required return demanded by stockholders will increase to 12.6 percent. Based on this information, should Nico make the change?

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

If we assume that EBIT is constant, the value of the firm is maximized by minimizing the weighted average cost of capital.

A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit of $3. What is its operating breakeven point if it desires net operating income of $10,000, not $0 (zero)?

Whenever the percentage change in earnings before interest and taxes resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists.

In theory, the firm should maintain financial leverage consistent with a capital structure that

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more total leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

Financial leverage may be defined as the potential use of variable financial costs to magnify the effects of changes in earnings before interest and taxes (EBIT) on the firm's earnings per share (EPS).

Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists.

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.

The conflict resulting from a manager's desire to increase the firm's risk without increasing current borrowing costs and lenders' desire to limit lending is one effect of the ________ problem.

The cost of equity is greater than the cost of debt and increases with increasing financial leverage, but generally less rapidly than the cost of debt.

Generally, increases in leverage result in increased return and risk, whereas decreases in leverage result in decreased return and risk.