Principles of Managerial Finance, 15th Edition

13.1 Leverage

1. LG1

2. LG2

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 fixed costs whether business conditions are good or bad. These costs may be operating costs, such as those incurred by purchasing and operating plant and equipment, or they may be financial costs, such as the fixed costs of making debt payments. We say that a firm with higher fixed costs has greater leverage. 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. ...