13-1

Leverage describes the impact that fixed costs have on the profitability of the company's owners.

We can calculate the operating leverage from the operating profit in the income statement considering
sales revenue and all operating expenses.

Financial leverage- We can obtain operational profit data, deduct taxes, interest paid, and preferred
stocks, and determine earnings per share.

Total leverage is a combination of the previous two types. To analyze their relationship, take the
revenue value of the income statement of the operating leverage and earnings per share from the
financial leverage.

13-2

The operating break-even point presents how much the company should sell to cover total operating
costs without additional earnings.

If the number of fixed expenses grows, the corporation must pay more, and the amount of sales must
increase to achieve a neutral net income.

A price rise is inversely related to the number of sales; hence an increase in price per unit will result in
fewer sold units.

If variable costs per unit rise, the corporation must incur more expenses, and in order to maintain a
neutral net income, sales must rise.

13-3

Operating leverage includes the operating fixed costs or cost of goods sold
13-4

Financial leverage includes fixed borrowing expenses that affect the owner's profitability but excludes
paid interest and tax payments.

13-5

If the corporation improves its operating leverage, the financial leverage may remain constant, but the
overall leverage would increase.

If the corporation raises its financial leverage by raising its debt, the amount of operating leverage can
stay constant. However, overall leverage will move in the same way as financial leverage.

13-6

Capital structure is a very complicated financial process related to all financial objectives in the
company. If the capital structure is not well composed, the company will lose potential profit.

3 ratios:

 debt to equity
 times interest earned ratio
 fixed payments coverage ratio

13-7
capital structures of U.S. and non–U.S differences:
  The capital markets in the United States are more developed than in any other country, which assists many
businesses in locating appropriate finance.
 Banks play a central role in the financial system in other nations, and businesses frequently borrow from
banks.
 Banks in other countries except for the U.S can invest in a nonfinancial corporation, in the U.S that is not
allowed.
 In other nations, ownership is more tightly restricted. The owners need help deciding what is best for the
firm, yet debt financing is forced on enterprises in countries other than the United States.

capital structures of U.S. and non–U.S similarities:

 Organizations that develop and grow through issuing patents and other intangible assets prefer
less debt funding than organizations with a larger proportion of tangible assets. This is because
enterprises with physical assets may provide collateral for borrowing as a guarantee.
 Large firms borrow more than tiny businesses all around the world. However, it also implies that
giant corporations are expanding while small businesses are stagnating.
 Companies with a high risk of default prefer equity financing over debt financing in all nations.
That is how a corporation will obtain extra money while paying nothing in return. Those
businesses are already hazardous; if they fail, the previous owners will lose less.

13-8

Companies prefer debt financing since interest is deducted and there is no change in ownership. The
company's owners make more money by "increasing" the net income value.

13-9

Every organization confronts business risk, which is the risk that the company will not complete its
operational activities. A greater degree of fixed cost, fluctuating sales revenues, changeable
manufacturing costs, and unexpected demand all contribute to an increase in this risk. If a company's
business risk is considerable, it will desire less leverage in its capital structure.

Companies confront financial danger due to their inability to pay their sources of financing. The financial
risk grows as the ratio of fixed debt obligations or preferred stock in the capital structure increases. The
company's finance department issues debt obligations or preferred shares; hence, this risk depends on
finance management.

13-10

Before the lender lends money to the company's owner, the contract and its conditions depend on how
the lender expects the owner to behave. But when all the conditions, rates, and maturity until repaying
the loan are obtained, the borrower can take over risky activities and increase the debt in the capital
structure.

The lender will lend money only if the firm's owner agrees not to grow the level of debt in the capital
structure, not to pay dividends, and not to engage in risky activities that will jeopardize the company.

13-11

The company's management and owners profit from asymmetric information more than potential
investors.
Investors are hesitant to invest in a company with high debt in its capital structure. It raises the
likelihood of default, and lenders will not receive their funds back.

13-12

The cost of equity is the return the firm gives its investors in exchange for their investment. WACC
(weighted average of capital costs) is the cost of all capital types in the capital structure.

In practice, the optimal capital structure is difficult to attain, but corporations aim to maximize it by
increasing the firm's value and lowering the discount rate as much as feasible.

13-13

13-14

The risk that the corporation is taking will raise financial leverage, and the owners' wealth will not be
maximized. The firm will face a liquidity crisis; investors will be unwilling to participate in a company
with such a high degree of risk, and financial institutions will refuse to lend to such a company.

13-15

The factors that the company should consider in deciding on the capital structure are the following

1. Stable revenue
2. Ability to generate cash flow
3. Contractual obligation
4. Control
5. External risk
6. Timing