The Effect Of Financial Leverage

The previous section described why the capital structure that produces the highest firm value (or the lowest cost of capital) is the one most beneficial to stockholders. In this section, we examine the impact of financial leverage on the payoffs to stockholders. As you may recall, financial leverage refers to the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

As we describe, financial leverage can dramatically alter the payoffs to shareholders in the firm. Remarkably, however, financial leverage may not affect the overall cost of capital. If this is true, then a firm's capital structure is irrelevant because changes in capital structure won't affect the value of the firm. We will return to this issue a little later.

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