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13 Cards in this Set
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**Ch 14: 1) Define leverage as it is used in finance.
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Leverage is the use of assets and liabilities with fixed costs in order to increase the returns to a firm's common stockholders.
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Define fixed costs and give examples
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Fixed costs are operating costs that are independent of sales levels in the short-run. These costs are primarily related to the passage of time. Examples include depreciation, rent, insurance, lighting and heating costs, property taxes, and the salaries of management.
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Define variable costs and give examples
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Variable costs are operating costs that move in close relationship to changes in sales. Variable costs are related to the output produced and sold, rather than the passage of time. Examples include raw material costs, direct labor costs, and salespersons' commissions.
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Define operating leverage
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Operating leverage is the employment of assets with fixed operating costs in an attempt to increase operating income (EBIT).
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Define financial leverage
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Financial leverage is the employment of funds having fixed capital costs in an attempt to increase EPS.
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How is a firm's degree of combined leverage (DCL) related to its degrees of operating and financial leverage?
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The degree of combined leverage (DCL) is equal to the degree of operating leverage (DOL) times the degree of financial leverage (DFL). This relationship shows that operating leverage and financial leverage can be combined in many different ways to achieve a given degree of combined leverage. High operating leverage can be offset with low financial leverage and vice versa.
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Is it possible for a firm to have a high degree of operating leverage and a low level of business risk? Explain
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Yes. The level of business risk of a firm relates to the variability of that firm's operating income. Even if a firm has a high degree of operating leverage, it is possible for it to have a stable level of operating income if prices, sales quantities, and the variable costs of production and marketing are stable over time.
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Is it possible for a firm to have a high degree of combined leverage and a low level of total risk? Explain
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Yes. If a firm has stable sales revenues and stable operating costs over time, the total risk of the firm will be low. The degree of combined leverage relates changes in EPS to changes in sales revenues. Thus, if sales revenues are relatively stable and variable operating costs are also stable, then EPS also will be stable.
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What are the major limitations of EBIT-EPS analysis as a technique to determine the optimal capital structure?
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Use of EBIT-EPS analysis can determine which financing alternative maximizes EPS. However, it is possible that maximizing EPS results in such a high risk level that the weighted cost of capital is not minimized, and therefore the value of the firm is not maximized.
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In practice, how can a firm determine whether it is operating at (or near) its optimal capital structure?
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A firm cannot tell exactly when it is at the optimal capital structure point. However, this is not a great problem because the optimal capital structure, in practice, is best depicted as a range. Many companies are able to conclude they are operating near the optimal range as a result of borrowing nearly as much as they can at reasonable interest rates. Comparison with other companies in the industry also should help the company determine whether it safely can increase its proportion of "moderate" debt and reduce its weighted cost of capital. Other techniques that can provide useful insight include EBIT-EPS analysis and cash insolvency analysis.
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**Under what circumstances should a firm use more debt in its capital structure than is used by the "average" firm in the industry? When should it use less debt than the "average" firm?
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A firm should use more debt if it traditionally has been more profitable than the average firm in the industry, or if its operating income is more stable than the operating income of the average firm in the industry. If the opposite factors (i.e., less profitable and less stable) are true, the firm generally should use less debt. This answer assumes that the average firm in the industry is operating at or near an optimal capital structure.
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Why do public utilities typically have capital structures with about 50 percent debt, whereas major oil companies average about 25 percent debt in their capital structures?
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Public utilities typically incur more financial risk than major oil companies because public utilities have less business risk than major oil companies. In general, the capital markets permit low business risk firms to incur a larger percentage of debt in their capital structures than high business risk firms.
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**What is cash insolvency analysis and how can it help in the establishment of an optimal capital structure?
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Cash insolvency analysis is a tool that can be used to analyze the effects of a proposed capital structure change. Cash insolvency analysis looks at the effects of a worst-case scenario of a firm’s cash balances and net cash flows when a firm is faced with a major recession, or downturn in its business. Cash insolvency analysis permits a manager to compute the probability of the firm running out of cash in a recession, given the fixed financial charges the firm faces with alternative capital structures.
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