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:
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!
M&M Proposition I
M&M Proposition II
Interest tax shield
Direct bankruptcy costs
Indirect bankruptcy costs
Financial distress costs
Static theory of capital structure
Absolute priority rule
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