Introduction to Finance

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Faster growth leads to greater fi nancing needs.
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Higher profi ts allow the fi rm to rely more on internal equity 
(additions to retained earnings) to fi nance growth.
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Higher dividend payouts lead to lower additions to retained 
earnings, less ability to rely on internal equity as a source of 
fi nancing, and greater reliance on capital markets to raise debt 
and equity. Since it is less costly to issue debt (and debt does not 
dilute the current stockholders’ ownership of the fi rm), fi rms 
tend to issue debt as external fi nancing source—something we 
fi rst saw back in Chapter 10’s Figure 10.1.
LO 18.6 
This chapter reviews EBIT/eps analysis. EBIT/eps analysis 
is used to compare two capital structures (usually a fi rm’s current cap-
ital structure and a proposed change). EBIT/eps analysis is a visual 
tool to help management see how sensitive eps is to changes in EBIT.
EBIT/eps analysis graphs combinations of EBIT and eps for each 
capital structure. Most of the time, there were be an “indiff erence 
point” where the two EBIT/eps lines cross. If management believes 
EBIT will fall below this indiff erence level, the lower debt capital 
structure will likely result in a higher earnings per share. If EBIT is 
likely to be greater than the indiff erence level, the more-highly lever-
aged capital structure will likely have higher earnings per share. 
LO 18.7 
This chapter reviews several tools used to examine a fi rm’s 
capital structure, including business risk, fi nancial risk, and combined 
leverage. Business risk is the variability of EBIT (operating income) 
over time. Items such as unit sales variability, variability in price-cost 
margins, and the level of fi xed operating costs aff ect a fi rm’s business 
risk. The higher the business risk, the less willing one may think that 
management would be to take on fi nancial risk. Financial risk occurs 
when there are fi xed fi nancing costs—that is, interest expense—in 
the fi rm’s capital structure. We can compute the degree of operating 
leverage (DOL) to estimate the eff ect of fi xed operating costs; DOL 
measures the eff ect on EBIT of a one percent change in sales revenue. 
The degree of fi nancial leverage (DFL) measures the impact of fi xed 
fi nancing costs; it equals the percentage change in earnings per share 

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Review Questions
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for each one percent change in EBIT. Taken together, if we multiply 
the DOL and DFL, we have the degree of combined leverage (DCL). 
The DCL measures the percent change in earnings per share of a one 
percent change in sales.