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Leverage refers to the effects that fixed costs have on the returns that shareholders earn.

By “fixed costs” we mean costs that do not rise and fall with changes in a firm’s sales. Firms
have to pay these fixed costs whether business conditions are good or bad. These fixed costs may
be operating costs, such as the costs incurred by purchasing and operating plant and equipment,
or they may be financial costs, such as the fixed costs of making debt payments. Generally,
leverage magnifies both returns and risks. A firm with more leverage may earn higher returns on
average than a firm with less leverage, but the returns on the more leveraged firm will also be
more volatile.

• Operating leverage is concerned with the relationship between the firm’s sales revenue and its
earnings before interest and taxes (EBIT) or operating profits. When costs of operations (such as
cost of goods sold and operating expenses) are largely fixed, small changes in revenue will lead
to much larger changes in EBIT.

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

• Total leverage is the combined effect of operating and financial leverage. It is concerned with
the relationship between the firm’s sales revenue and EPS.

Firms use breakeven analysis, also called cost-volume-profit analysis, (1) to determine
the level of operations necessary to cover all costs and (2) to evaluate the profitability associated
with various levels of sales.


Fixed Costs and Operating Leverage Changes in fixed operating costs affect operating
leverage significantly. Firms sometimes can alter the mix of fixed and variable costs in their
operations. For example, a firm could make fixed-dollar lease payments rather than payments
equal to a specified percentage of sales. Or it could compensate sales representatives with a fixed
salary and bonus rather than on a pure percent-of-sales commission basis. The effects of changes
in fixed operating costs on operating leverage can best be illustrated by continuing our example.

Financial leverage results from the presence of fixed financial costs that the firm must pay. Using
the framework in Table 13.1, we can define financial leverage as:

The use of fixed financial costs is to magnify the effects of changes in earnings before interest
and taxes on the firm’s earnings per share. The two most common fixed financial costs are (1)
interest on debt and (2) preferred stock dividends. These charges must be paid regardless of the
amount of EBIT available to pay them.

We also can assess the combined effect of operating and financial leverage on the firm’s
risk by using a framework similar to that used to develop the individual concepts of leverage.
This combined effect, or total leverage, can be defined as the use of fixed costs, both operating
and financial, to magnify the effects of changes in sales on the firm’s earnings per share. Total
leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and
financial structure.

Capital structure is one of the most complex areas of financial decision making because of its
interrelationship with other financial decision variables. 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.
The cost of debt is lower than the cost of other forms of financing. Lenders demand
relatively lower returns because they take the least risk of any contributors of long-term capital.
Lenders have a higher priority of claim against any earnings or assets available for payment, and
they can exert far greater legal pressure against the company to make payment than can owners
of preferred or common stock.

The tax deductibility of interest payments also lowers the debt cost to the firm
substantially. Unlike debt capital, which the firm must eventually repay, equity capital remains
invested in the firm indefinitely—it has no maturity date. The two basic sources of equity capital
are (1) preferred stock and (2) common stock equity, which includes common stock and retained
earnings. Common stock is typically the most expensive form of equity, followed by retained
earnings and then preferred stock. Our concern here is the relationship between debt and equity
capital. In general, the more debt a firm uses, the greater will be the firm’s financial leverage.
That leverage makes the claims of common stockholders even more risky. In addition, a firm that
increases its use of leverage significantly can see its cost of debt rise as lenders begin to worry
about the firm’s ability to repay its debts. Whether the firm borrows very little or a great deal, it
is always true that the claims of common stockholders are riskier than those of lenders, so the
cost of equity always exceeds the cost of debt.

We saw earlier that financial leverage results from the use of fixed-cost financing, such
as debt and preferred stock, to magnify return and risk. The amount of leverage in the firm’s
capital structure can affect its value by affecting return and risk. Those outside the firm can make
a rough assessment of capital structure by using measures found in the firm’s financial
statements. For example, a direct measure of the degree of indebtedness is the debt ratio (total
liabilities total assets). The higher this ratio is, the greater the relative amount of debt (or
financial leverage) in the firm’s capital structure. Measures of the firm’s ability to meet
contractual payments associated with debt include the times interest earned ratio (EBIT interest)
and the fixed payment coverage ratio. These ratios provide indirect information on financial
leverage. Generally, the smaller these ratios, the greater the firm’s financial leverage and the less
able it is to meet payments as they come due. The level of debt (financial leverage) that is
acceptable for one industry or line of business can be highly risky in another, because different
industries and lines of business have different operating characteristics.