Introduction to Finance

DISCUSSION QUESTION 2
EBIT/eps analysis is a simple tool fi nancial managers can use. How good of a tool do 
you believe it is? Does it make any assumptions that should be considered as part of the 
decision process to change a fi rm’s capital structure?
18.7
Combined Operating and 
Financial Leverage Eff ects
Business risk is determined by the products the fi rm sells and the production processes it uses. 
The eff ects of business risk are seen in the variability of operating income or EBIT over time. 
In fact, one popular measure of a fi rm’s business risk is the standard deviation of EBIT.
14
Table 18.5
shows a simplifi ed income statement. Because business risk is measured by 
variability in EBIT or operating income, line items that aff ect business risk appear on the top 
business risk 
measured by 
variability in EBIT over time and is 
determined by the products the fi rm 
sells and the production processes 
it uses
Debt to Total
Assets (%)
Firm
Value
eps
Maximum Firm
Value Capital
Structure
Maximum eps
Capital
Structure
$ Firm value, eps
FIGURE 18.7
 Firm Value, 
Earnings per Share, and Debt 
Ratios
14
To control for the eff ects of fi rm size when comparing diff erent fi rms, some use the standard deviation of operating 
return on assets; that is, the standard deviation of EBIT/Total assets.

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18.7 Combined Operating and Financial Leverage Eff ects
585
half of the income statement between sales revenue and EBIT. This suggests that a fi rm’s busi-
ness risk is aff ected by three major infl uences: unit volume or quantity sold, the relationship 
between selling price and variable costs, and the fi rm’s fi xed costs.
Unit Volume Variability
Variability in the quantity sold of the fi rm’s products or services will cause variation in sales 
revenue, variable costs, and operating income. Fluctuating sales volumes can arise from factors 
such as pricing strategy from competitive products, new technologies or products, customer 
impressions of product or service quality, and other factors aff ecting customer brand loyalty.
Price-Variable Cost Margin
A second factor aff ecting business risk is the fi rm’s ability to maintain a constant, positive 
diff erence between price and per-unit variable costs. If the margin between price and cost 
fl uctuates, the fi rm’s operating income will fl uctuate, too. Competitive pricing pressures, input 
supply shocks, labor union contracts, and other cost infl uences can cause the price–variable 
cost margin to vary over time, thus contributing to business risk.
Fixed Costs 
The variability of sales or revenues over time is a basic operating risk. Furthermore, when fi xed 
operating costs, such as rental payments, lease payments, contractual employee salaries, and 
general and administrative overhead expenses exist, they create operating leverage and increase 
business risk. Since fi xed costs do not rise and fall along with sales revenues, fl uctuating reven-
ues lead to variability in operating income or earnings before income and taxes (EBIT). As we 
learned in Chapter 14, the eff ect of operating leverage is that a given percentage change in net 
sales will result in a greater percentage change in operating income, or EBIT.
Operating leverage aff ects the top portion of a fi rm’s income statement, as shown in Table 18.5. 
It relates changes in sales to changes in EBIT, or operating income. We saw in Chapter 14 that the 
eff ect of fi xed operating costs on a fi rm’s business risk can be measured by the degree of operating 
leverage (DOL). Equation 18-9 repeats these relationships from Chapter 14:
DOL =
Percentage change in EBIT
Percentage change in sales
=
Sales − Variable cost
Sales − Variable cost − Fixed cost
(18-9)
In a similar fashion, when money is borrowed, fi nancial leverage will be created as the fi rm 
will have a fi xed fi nancial obligation, or interest, to pay. Financial leverage aff ects the bottom 
half of a fi rm’s income statement. A given percentage change in the fi rm’s EBIT will produce 
a larger percentage change in the fi rm’s net income, or eps. A small percentage change in 
EBIT may be levered or magnifi ed into a larger percentage change in net income.