10.7: Key Terms

This section provides concise definitions of key financing decisions, cost of capital, WACC, leverage, and dividend policy terms introduced in Chapter 10. These definitions are presented in a static, printable format for reference and exam preparation. When viewed online, additional dynamic highlighting of terms may be available.

Term	Definition
After-tax cost of debt	The cost of debt adjusted for the tax deductibility of interest: \(k_D(1-T_c)\). This is the relevant debt cost used in WACC.
Capital structure	The firm’s long-term financing mix, typically consisting of debt, preferred stock, and common equity, used to fund assets and operations.
Capital structure weights	The fractions of total firm value financed by each component (debt, preferred, equity), usually computed using market values: \(w_i=V_i/\sum V\).
Combined leverage (DCL)	The sensitivity of EPS to changes in sales, capturing both operating and financial leverage: \(\text{DCL}=\text{DOL}\times\text{DFL}=\frac{\%\Delta \text{EPS}}{\%\Delta \text{Sales}}\).
Cost of capital	A required return demanded by capital providers (lenders and investors). It is not an accounting expense; it reflects opportunity cost given risk.
Cost of debt (kD)	The market’s required return on the firm’s borrowing, commonly estimated by yield to maturity (YTM) for traded bonds or the current borrowing rate for similar loans.
Cost of equity (kE)	The required return demanded by common stockholders. Often estimated using CAPM or the dividend growth (DDM) approach.
Cost of preferred stock (kP)	The required return on preferred stock, often approximated as a dividend yield: \(k_P=\frac{D_P}{P_P}\), where \(D_P\) is the annual preferred dividend.
Degree of financial leverage (DFL)	The sensitivity of EPS to changes in EBIT due to fixed interest expense: \(\text{DFL}=\frac{\%\Delta \text{EPS}}{\%\Delta \text{EBIT}}=\frac{\text{EBIT}}{\text{EBIT}-\text{Interest}}\).
Degree of operating leverage (DOL)	The sensitivity of EBIT to changes in sales due to fixed operating costs: \(\text{DOL}=\frac{\%\Delta \text{EBIT}}{\%\Delta \text{Sales}}=\frac{\text{Sales}-\text{VC}}{\text{Sales}-\text{VC}-\text{FC}}\).
Dividend policy	The firm’s approach to distributing earnings to shareholders versus retaining earnings for reinvestment, affecting internal financing capacity and growth.
Dividend Discount Model (DDM)	A cost of equity (and valuation) approach for dividend-paying firms: \(k_E=\frac{D_1}{P_0}+g\), where \(D_1\) is next period’s dividend and \(g\) is expected growth.
EPS–EBIT indifference point	The EBIT level at which two financing plans produce the same EPS, used to compare debt versus equity financing trade-offs.
Financial leverage	Leverage created by fixed financing charges (primarily interest). Higher financial leverage increases EPS sensitivity to changes in EBIT.
Interest tax shield	The tax savings created because interest is tax-deductible. The after-tax cost of debt is lower than the pre-tax cost due to this shield.

Term	Definition
Marginal WACC	The cost of the next dollar of new capital raised. If new financing is more expensive than existing financing, marginal WACC can exceed current WACC.
Market value weights	WACC weights based on the current market values of debt, preferred, and equity. Used because investor required returns reflect current prices, not historical book values.
Market risk premium	The expected excess return of the market over the risk-free rate, \(E[R_m]-r_f\), used in CAPM to estimate the cost of equity.
Operating leverage	Leverage created by fixed operating costs (such as rent, depreciation, and salaries). Higher operating leverage increases EBIT sensitivity to sales changes.
Payout ratio	The fraction of net income paid to shareholders as dividends: \(\text{Payout}=\frac{\text{Dividends}}{\text{Net Income}}\).
Preferred stock	A hybrid security that typically pays a fixed dividend and has priority over common stock in dividend payments, but usually has limited or no voting rights.
Project risk adjustment	Modifying the discount rate upward for riskier-than-average projects or downward for safer projects, instead of using firm-wide WACC mechanically.
Required return	The return investors demand given risk. In corporate finance, required return is used as the discount rate for valuation and capital budgeting decisions.
Retention ratio (plowback)	The fraction of net income retained in the firm for reinvestment: \(b=1-\text{Payout}\). Retained earnings are an internal source of equity financing.
Risk-free rate (rf)	The return on an investment with minimal default risk over a comparable horizon (often proxied by U.S. Treasury yields), used in CAPM.
Sustainable growth rate	An approximate measure of how fast a firm can grow using internal equity financing, often summarized as \(g \approx \text{ROE}\times b\).
Trade-off theory	The idea that optimal leverage balances the benefits of debt (tax shield) against the expected costs of financial distress and agency problems.
Weighted average cost of capital (WACC)	The firm’s blended required return across financing sources, used as a hurdle rate for average-risk projects: \(\text{WACC}=w_Dk_D(1-T_c)+w_Pk_P+w_Ek_E\).
Yield to maturity (YTM)	The bond’s internal rate of return if held to maturity, based on current price, coupon payments, and par value. Commonly used to estimate the pre-tax cost of debt.

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