Professor Rosilyn Overton | Chapter 13 – Leverage and Capital Structure
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Chapter 13 – Leverage and Capital Structure

There Is No Special Assignment For This Chapter!

In this chapter, we talk about debt and its often unfortunate consequence, bankruptcy. The judicious use of debt can make a company more profitable and give greater return to shareholders. Over use of leverage (debt=leverage) can lead to disaster and the breakup of the firm.


First, let’s examine why it is called leverage. Just as a lever can allow you to lift a greater weight than you could straight on, thereby multiplying your strength, the use of debt can allow a company to do more than it could with just its own capital alone. But leverage works both ways — just as it can multiply return when properly used, it can multiply losses when things don’t go as planned.



When you finish your study of this chapter, you should know:


  1. You should understand more fully the effects of leverage,
  2. You should know the effects of bankruptcy and taxes on capital structure choice, and
  3. You should understand the basics of the bankruptcy process.

The following are terms that you should be able to define perfectly when you finish studying this chapter. Make your flash cards and take them with you, reviewing them whenever you have a chance. You will be a happy test taker!


Key terminology:

Homemade leverage
M&M Proposition I
M&M Proposition II
Business risk
Financial risk
Interest tax shield
Direct bankruptcy costs
Indirect bankruptcy costs
Financial distress costs
Static theory of capital structure
Absolute priority rule

Don’t forget! Homework is due by 6:30 PM on class day by e-mail to! Don’t suffer a zero by being late.