6 Discuss the limitations of financial leverage Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage cred itors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature 5-7 How does the interest rate on new debt influence the use of financial leverage? The higher the interest rate on new debt, the less attractive financial leverage is to the firm Explain how combined leverage brings together operating income and earnings per share point, financial leverage takes over and determines the overall impact on his Operating leverage primarily affects the operating income of the firm. At earnings per share. a delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5 5-9 Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point At progressively higher levels of operations than the break- -even point, t In sult of a percentage cha unit volume diminishes. The reason is primarily mathematical -as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less 5-10 When you are considering two different financing plans, does being at the level where earnings per share are equal between the two plans always mean you are indifferent as to which plan is selected? The point of equality only measures indifference based on earnings per share Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt Copyright o2005 by The McGranr-Hill Companies, Inc.Copyright © 2005 by The McGraw-Hill Companies, Inc. S-160 5-6. Discuss the limitations of financial leverage. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 5-7. How does the interest rate on new debt influence the use of financial leverage? The higher the interest rate on new debt, the less attractive financial leverage is to the firm. 5-8. Explain how combined leverage brings together operating income and earnings per share. Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5. 5-9. Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point. At progressively higher levels of operations than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical — as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 5-10. When you are considering two different financing plans, does being at the level where earnings per share are equal between the two plans always mean you are indifferent as to which plan is selected? The point of equality only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt