1. Understand that the degree of operating leverage (DOL) is defined as the percentage change in EBIT resulting from a 1 percent change in sales
a. The degree of operating leverage approaches a maximum as the firm comes closer to operating at its break-even level of output
b. All other things being equal, the higher a firm’s DOL, the greater is its business risk
c. Business risk, the inherent variability of a firm’s EBIT, is also influenced by the variability of sales and operating costs over time
2.Understand that the degree of financial leverage (DFL) is defined as the percentage change in earnings per share (EPS) resulting from a 1 percent change in EBIT
a. The degree of financial leverage approaches a maximum as the firm comes closer to operating at its loss level, the level where EPS 5 $0
b. All other things being equal, the higher a firm’s DFL, the greater is its financial risk
c. Financial risk, the additional variability of a firm’s EPS that results from the use of financial leverage, can also be measured by various financial ratios, such as the debt to total assets ratio and the times interest earned ratio
3. Understand that the degree of combined leverage (DCL) is defined as the percentage change in earnings per share resulting from a 1 percent change in sales. It is also equal to the DOL for a firm times that firm’s DFL. The degree of combined leverage used by a firm is a measure of the overall variability of EPS due to the use of fixed operating and capital costs, as sales levels change
4. Understand that EBIT-EPS analysis is an analytical technique that can be used to help determine the circumstances under which a firm should employ financial leverage. The indifference point in EBIT-EPS analysis is that level of EBIT where earnings per share are the same regardless of which of two alternative capital structures is used
5. Understand that cash insolvency analysis can be used to evaluate the impact of a proposed capital structure on the cash position of a firm during a major business downturn
6. Understand that other factors that should be considered when establishing a capital structure policy are industry standards, profitability and need for funds, lender requirements, managerial risk aversion, and the desire of owners to retain control of the firm
