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 outsiders, such as external shareholders, credits, suppliers, and customers have less and inferior information about a firms past, current, and future conditions and prospects, compared to the firms managers.
The extent to which a firms cost structure contains a large proportion of fixed costs, which raises its level of business risk if the firms sales decline.
This practice of employing a large proportion of fixed-cost sources of financing, such as debt securities and preferred stock, exposes a firms stockholders to more business risk.
The financial flexibility available to a firm which allows it to borrow additional debt capital when needed or desired as a result of using less than the optimal level of debt in its current capital structure.
An action taken by a firms management that provides clues to investors about how management views the firms prospects.
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 a firms earnings per share (EPS) are the same, regardless of which of two alternative capital structures are compared.
The mix of debt, preferred stock, and common stock that minimizes a firms weighted average cost of capital.
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.