Business Management Homework Help CH 6 2. Operating leverage is the substitution of fixed- for variable-cost methods of production. Like financial leverage, sales must increase to cover the higher fixed costs, but once covered, profits rise more rapidly. Financial leverage requires higher cash flows to cover the higher interest payments, but once covered, profits accruing to shareholders grow more quickly with additional sales. One would not expect to find both high operating leverage and high financial leverage at the same firm, as both types of leverage magnify the risks borne by equity 3. Because all firms face business risk, company EBIT varies over time. Debt is a fixed income security, meaning interest expense does not vary with EBIT. As a result, all of the variability in EBIT is borne by equity investors, who hold a residual income security. As leverage increases, the same variability in EBIT is borne by a smaller equity investment, causing variability per dollar invested to rise. This results in increased volatility in shareholder returns or increased risk. Also, as evident from the range of earnings chart, leverage increases the slope of line relating EBIT to EPS or ROE, and the steeper the slope, the greater the variability in EPS, and ROE, for any given variability in EBIT. 4. Companies can incur significant costs of financial distress without going bankrupt. In fact, these costs are often much larger than the cost of bankruptcy itself. Costs include lost profit opportunities due to cut backs in investment, R&D, and marketing to conserve cash. They also include lost sales as potential buyers worry about the ability of the business to service its products and increased costs as suppliers become less willing to enter into long run contracts and to provide trade credit. In knowledge-based companies, top producers may depart as the companyâ€™s stock-based compensation becomes less attractive. Detrimental conflicts of interest among owners, creditors, and managers can also arise when a company gets into financial difficulty, even in the absence of formal bankruptcy.
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