1. Basic concepts

Select the correct term for each of the following descriptions. These are not necessarily complete definitions, but there is only one possible answer for each term.

Descriptions	Terms
The level and nature of risk attributable to a firms activities and operations, and ignoring the risks associated with the firms capital structure.
The situation in which managers have different, and usually better, information about their firms past, current, and future conditions and prospects, compared to outsiders, such as external investors, creditors, suppliers, and customers.
A firms use of relatively high fixed, as opposed to variable, operating costs, such as capital-intensive productive processes instead of labor-intensive methods.
The practice of employing a capital structure that contains a large proportion of fixed-cost sources of financing, such as debt securities and preferred stock.
The ability of a firm to borrow money at a reasonable cost when good investment opportunities arise because it currently less debt than that suggested by its optimal capital structure.
Managements decision to issue new common stock versus new debt securities in response to its evaluation of the firms future opportunities.
The risk to the firms shareholders resulting from managements decision to employ fixed-cost financing sources in the firms capital structure.
The level of sales at which the firms earnings per share (EPS) is the same, and there is no advantage to using more debt or more equity in the firms capital structure.
The mix of debt, preferred stock, and common stock that maximizes the price of the firms common stock.
The combination of common equity, preferred stock, and debt capital used to finance a firms assets.

In making capital structure decisions, managers must manage the firms level of operating leverage and financial leverage, and the firms exposure to business and financial risks. This requires knowledge of a firms degree of operating leverage (DOL), financial leverage (DFL), and total leverage (DTL).

Complete the following table by identifying the correct formula and completing the interpretative statement.

Formula	Interpretation
Degree of operating leverage (DOL)
	An index for a of sales that measures the effect of a change in sales (S) on the firms operating income (EBIT). Alternatively, it is an indicator of the riskiness (variability) of a firms EBIT to the use of fixed costs (F) in the firms cost structure.
Degree of financial leverage (DFL)
	An index for a specific range of sales that measures the effect of a change in EBIT on a firms earnings per share (EPS). At a constant level of sales, the DFL value will vary with a change in the amount of interest expense (I) incurred. This implies that the DFL is an indicator of a firms risk.
Degree of total leverage (DTL)
	An index of the firms total risk resulting from its use of operating and financial leverage. Stated differently, it is an indicator of the consequences for the firms EPS for its use of operating and financing costs.

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