Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage generally has no effect on EBIT—it only affects EPS, given EBIT.
Because Firm A has a higher fixed operating costs, its operating income will change by a greater percentage than Firm B’s operating income if sales change. Firm A has a higher degree of operating leverage than Firm B.
If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges also will vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.
The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-5 in the textbook.
Carson does have leverage because its EPS increases by a greater multiple than its sales when sales change. According to the information that is given, Carson’s DTL is 4 = 20/5. Because we have no information about either the firm’s operating fixed costs or its fixed financing costs, we cannot state whether the firm has operating leverage, financial leverage, or both.
EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage, because interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm’s future.
Expected EPS generally is measured as EPS for the coming years, and we typically do not reflect in this calculation any bankruptcy-related costs. Also, EPS does not reflect (in a major way) the increase in risk and ks that accompanies an increase in the debt ratio, whereas P0 does reflect these factors. Thus, the stock price will be maximized at a debt level that is lower than the EPS-maximizing debt level.
A firm can change the proportion of debt it uses in its capital structure. If the firm has too much (little) debt, it can reduce (increase) the proportion of debt in its capital structure. Such as change should decrease the firm’s WACC, and thus increase its value.
Absolute’s optimal capital structure is 40 percent debt (= $20,000,000/$50,000,000), because the market price of the company’s stock ($130.75) is maximized at this point.
With increased competition after the breakup of AT&T, the new AT&T and the seven Bell operating companies’ business risk increased. With this component of total company risk increasing, the new companies probably decided to reduce their financial risk, and use less debt, to compensate. With increased competition the chance of bankruptcy increases and lowering debt usage makes this less of a possibility. If we consider the tax issue alone, interest on debt is tax deductible; thus, the higher the firm’s tax rate the more beneficial the deductibility of interest is. However, competition and business risk have tended to outweigh the tax aspect as we saw from the actual debt ratios of the Bell companies. The Bell companies and the new AT&T lowered their debt ratios, for reasons along these lines.
Several possibilities exist for the firm, but trying to match the length of the project with the maturity of the financing plan seems to be the best approach. The firm might want to finance the R&D with short-term debt and then, if the project’s results are successful, to raise the needed capital for production through long-term debt or equity. Another possibility would be to issue convertible...
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