Managerial Finance

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Managerial Finance

© All Rights Reserved

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Leverage

and Capital

Structure

Learning Goals

1. Discuss leverage, capital structure, breakeven

analysis, the operating breakeven point, and the

effect of changing costs on it.

2. Understand operating, financial, and total leverage

and the relationship among them.

3. Describe the basic types of capital, external

assessment of capital structure, the capital structure

of non-U.S. firms, and capital structure theory.

11-2

Learning Goals

4. Explain the optimal capital structure using a graphical

view of the firms cost of capital functions and a zerogrowth valuation model.

5. Discuss the EBIT-EPS approach to capital structure.

6. Review the return and risk of alternative capital

structures, their linkage to market value, and other

important capital structure considerations related to

capital structure.

Copyright 2009 Pearson Prentice

11-3

Leverage

Leverage results from the use of fixed-cost assets or funds to

magnify returns to the firms owners.

Generally, increases in leverage result in increases in risk and

return, whereas decreases in leverage result in decreases in risk

and return.

The amount of leverage in the firms capital structurethe mix

of debt and equitycan significantly affect its value by affecting

risk and return.

11-4

Leverage (cont.)

Table 11.1 General Income Statement Format and Types

of Leverage

11-5

Breakeven Analysis

Breakeven (cost-volume-profit) analysis is used to:

determine the level of operations necessary to cover all

operating costs, and

evaluate the profitability associated with various levels of

sales.

level of sales necessary to cover all operating expenses.

At the OBP, operating profit (EBIT) is equal to zero.

11-6

To calculate the OBP, cost of goods sold and operating expenses

must be categorized as fixed or variable.

Variable costs vary directly with the level of sales and are a

function of volume, not time.

Examples would include direct labor and shipping.

Fixed costs are a function of time and do not vary with sales

volume.

Examples would include rent and fixed overhead.

11-7

Breakeven Analysis:

Algebraic Approach

Using the following variables, the operating portion

of a firms income statement may be recast as

follows:

P

FC =

VC =

EBIT = (P x Q) - FC - (VC x Q)

Copyright 2009 Pearson Prentice

11-8

Breakeven Analysis:

Algebraic Approach (cont.)

11-9

Breakeven Analysis:

Algebraic Approach (cont.)

Analysis

11-

Breakeven Analysis:

Algebraic Approach (cont.)

Example: Cheryls Posters has fixed operating

costs of $2,500, a sales price of $10 per

poster, and variable costs of $5 per poster.

Find the OBP.

Q =

$10 - $5

posters, its revenues will just equal its costs

(EBIT = $0).

Copyright 2009 Pearson Prentice

11-11

Breakeven Analysis:

Algebraic Approach (cont.)

We can check to verify that this is the case by

substituting as follows:

EBIT = (P x Q) - FC - (VC x Q)

EBIT = ($10 x 500) - $2,500 - ($5 x 500)

Copyright 2009 Pearson Prentice

11-

Breakeven Analysis:

Graphical Approach

Figure 11.1 Breakeven Analysis

11-

and the Operating Breakeven Point

of several options: (1) increasing fixed operating costs to

$3,000, (2) increasing the sale price per unit to $12.50, (3)

increasing the variable operating cost per unit to $7.50, and

(4) simultaneously implementing all three of these changes.

11-

and the Operating Breakeven Point

(1) Operating BE point = $3,000/($10-$5) = 600 units

(2) Operating BE point = $2,500/($12.50-$5) = 333 units

(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units

(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units

11-

and the Operating Breakeven Point

Table 11.3 Sensitivity of Operating Breakeven Point

to Increases in Key Breakeven Variables

11-

Operating Leverage

Figure 11.2

Operating

Leverage

11-

Table 11.4 The EBIT for Various Sales Levels

11-

Degree of Operating Leverage

The degree of operating leverage (DOL) measures the

sensitivity of changes in EBIT to changes in Sales.

A companys DOL can be calculated in two different

ways: One calculation will give you a point estimate,

the other will yield an interval estimate of DOL.

Only companies that use fixed costs

in the production process will experience operating

leverage.

Copyright 2009 Pearson Prentice

11-

Degree of Operating Leverage (cont)

DOL = Percentage change in EBIT

Percentage change in Sales

12.4 yields:

Case 1: DOL = (+100% +50%) = 2.0

Case 2: DOL = (-100% -50%) = 2.0

11-

Degree of Operating Leverage (cont)

A more direct formula for calculating DOL at a base

sales level, Q, is shown below.

DOL at base Sales level Q =

Q X (P VC)

Q X (P VC) FC

yields the following result:

DOL at 1,000 units =

= 2.0

1,000 X ($10 - $5) - $2,500

11-

and Operating Leverage

Assume that Cheryls Posters exchanges a portion of its

variable operating costs for fixed operating costs by

eliminating sales commissions and increasing sales

salaries. This exchange results in a reduction in variable

costs per unit from $5.00 to $4.50 and an increase in

fixed operating costs from $2,500 to $3,000

DOL at 1,000 units =

= 2.2

1,000 X ($10 - $4.50) - $2,500

11-

and Operating Leverage (cont.)

Table 11.5 Operating Leverage and Increased Fixed Costs

11-

Financial Leverage

Financial leverage results from the presence of fixed

financial costs in the firms income stream.

Financial leverage can therefore be defined as the

potential use of fixed financial costs to magnify the

effects of changes in EBIT on the firms EPS.

The two fixed financial costs most commonly found on

the firms income statement are (1) interest on debt and

(2) preferred stock dividends.

Copyright 2009 Pearson Prentice

11-

Chen Foods, a small Oriental food company, expects EBIT of

$10,000 in the current year. It has a $20,000 bond with a

10% annual coupon rate and an issue of 600 shares of $4

annual dividend preferred stock. It also has 1,000 share of

common stock outstanding.

The annual interest on the bond issue is $2,000 (10% x

$20,000). The annual dividends on the preferred stock are

$2,400 ($4/share x 600 shares).

Copyright 2009 Pearson Prentice

11-

Table 11.6 The EPS for Various EBIT Levelsa

11-

Degree of Financial Leverage

The degree of financial leverage (DFL) measures the

sensitivity of changes in EPS to changes in EBIT.

Like the DOL, DFL can be calculated in two different

ways: One calculation will give you a point estimate,

the other will yield an interval estimate of DFL.

Only companies that use debt or other forms of fixed

cost financing (like preferred stock) will experience

financial leverage.

Copyright 2009 Pearson Prentice

11-

Degree of Financial Leverage (cont)

DFL = Percentage change in EPS

Percentage change in EBIT

12.6 yields:

Case 1: DFL = (+100% +40%) = 2.5

Case 2: DFL = (-100% -40%) = 2.5

11-

Degree of Financial Leverage (cont)

A more direct formula for calculating DFL at a base level

of EBIT is shown below.

DFL at base level EBIT =

EBIT

EBIT I [PD x 1/(1-T)]

the tax rate, T = 40% yields the following result:

DFL at $10,000 EBIT =

$10,000

$10,000 $2.000 [$2,400 x 1/(1-.4)]

DFL at $10,000 EBIT = 2.5

Copyright 2009 Pearson Prentice

11-

Total Leverage

Total leverage results from the combined effect

of using fixed costs, both operating and

financial, to magnify the effect of changes in

sales on the firms earnings per share.

Total leverage can therefore be viewed as the

total impact of the fixed costs in the firms

operating and financial structure.

11-

Cables Inc., a computer cable manufacturer, expects sales of

20,000 units at $5 per unit in the coming year and must meet

the following obligations: variable operating costs of $2 per

unit, fixed operating costs of $10,000, interest of $20,000,

and preferred stock dividends of $12,000. The firm is in the

40% tax bracket and has 5,000 shares of common stock

outstanding. Table 12.7 on the following slide summarizes

these figures.

Copyright 2009 Pearson Prentice

11-

Degree of Total Leverage

DTL = Percentage change in EPS

Percentage change in Sales

yields:

Degree of Total Leverage (DTL) = (300% 50%) = 6.0

11-

Degree of Total Leverage (cont.)

A more direct formula for calculating DTL at a base level of

Sales, Q, is shown below.

DTL at base sales level =

Q x (P VC)

Q x (P VC) FC I [PD x 1/(1-T)]

$20,000, PD = $12,000, and the tax rate, T = 40% yields the

following result:

DTL at 20,000 units =

20,000 X ($5 $2)

20,000 X ($5 $2) $10,000 $20,000 [$12,000 x 1/(1-.4)]

11-

Financial and Total Leverage

in the following equation:

DTL = DOL x DFL

Applying this to our previous example we get:

DTL = 1.2 X 5.0 = 6.0

11-

Table 11.7 The Total Leverage Effect

11-

Capital structure is one of the most complex areas of

financial decision making due to its interrelationship

with other financial decision variables.

Poor capital structure decisions can result in a high cost

of capital, thereby lowering project NPVs and making

them more unacceptable.

Effective decisions can lower the cost of capital,

resulting in higher NPVs and more acceptable projects,

thereby increasing the value of the firm.

Copyright 2009 Pearson Prentice

11-

Types of Capital

11-

Table 11.8 Debt Ratios for Selected Industries and Lines of Business

(Fiscal Years Ended 4/1/05 through 3/31/06)

11-

In recent years, researchers have focused attention not

only on the capital structures of U.S. firms, but on the

capital structures of foreign firms as well.

In general, non-U.S. companies have much higher

degrees of indebtedness than their U.S. counterparts.

In most European and Pacific Rim countries, large

commercial banks are more actively involved in the

financing of corporate activity than has been true in the

U.S.

Copyright 2009 Pearson Prentice

11-

Capital Structure

of Non-U.S. Firms (cont.)

Furthermore, banks in these countries are permitted to make

large equity investments in non-financial corporationsa

practice forbidden in the U.S.

However, similarities also exist between U.S. firms and their

foreign counterparts.

For example, the same industry patterns of capital structure tend

to be found around the world.

In addition, the capital structures of U.S.-based MNCs tend to be

similar to those of foreign-based MNCs.

Copyright 2009 Pearson Prentice

11-

According to finance theory, firms possess a target

capital structure that will minimize its cost of capital.

Unfortunately, theory can not yet provide financial

mangers with a specific methodology to help them

determine what their firms optimal capital structure

might be.

Theoretically, however, a firms optimal capital

structure will just balance the benefits of debt financing

against its costs.

Copyright 2009 Pearson Prentice

11-

The major benefit of debt financing is the tax shield

provided by the federal government regarding interest

payments.

The costs of debt financing result from:

the increased probability of bankruptcy caused by debt obligations,

the agency costs resulting from lenders monitoring the firms

actions, and

the costs associated with the firms managers having more

information about the firms prospects than do investors

(asymmetric information).

11-

Tax Benefits

Allowing companies to deduct interest payments when

computing taxable income lowers the amount of

corporate taxes.

This in turn increases firm cash flows and makes more

cash available to investors.

In essence, the government is subsidizing the cost of

debt financing relative to equity financing.

11-

Probability of Bankruptcy

The probability that debt obligations will lead to

bankruptcy depends on the level of a companys business

risk and financial risk.

Business risk is the risk to the firm of being unable to

cover operating costs.

In general, the higher the firms fixed costs relative to

variable costs, the greater the firms operating leverage

and business risk.

Business risk is also affected by revenue and cost stability.

11-

Probability of Bankruptcy (cont.)

The firms capital structurethe mix between debt

versus equitydirectly impacts financial leverage.

Financial leverage measures the extent to which a firm

employs fixed cost financing sources such as debt and

preferred stock.

The greater a firms financial leverage, the greater will

be its financial riskthe risk of being unable to meet

its fixed interest and preferred stock dividends.

Copyright 2009 Pearson Prentice

11-

Imposed by Lenders

When a firm borrows funds by issuing debt, the interest rate

charged by lenders is based on the lenders assessment of the risk

of the firms investments.

After obtaining the loan, the firms stockholders and/or managers

could use the funds to invest in riskier assets.

If these high risk investments pay off, the stockholders benefit

but the firms bondholders are locked in and are unable to share

in this success.

11-

Imposed by Lenders (cont.)

To avoid this, lenders impose various

monitoring costs on the firm.

Examples would of these monitoring

costs would:

include raising the rate on future debt issues,

denying future loan requests,

imposing restrictive bond provisions.

Copyright 2009 Pearson Prentice

11-

Asymmetric Information

Asymmetric information results when managers of a

firm have more information

about operations and future prospects than

do investors.

Asymmetric information can impact the firms capital

structure as follows:

Suppose management has identified an extremely lucrative

investment opportunity and needs to raise capital. Based on

this opportunity, management believes its stock is

undervalued since the investors have no information about

the investment.

Copyright 2009 Pearson Prentice

11-

Asymmetric Information (cont.)

Asymmetric information results when

managers of a firm have more information

about operations and future prospects than

do investors.

Asymmetric information can impact the firms capital

structure as follows:

In this case, management will raise the funds using debt

since they believe/know the stock is undervalued

(underpriced) given this information. In this case, the use of

debt is viewed as a positive signal to investors regarding the

firms prospects.

Copyright 2009 Pearson Prentice

11-

Asymmetric Information (cont.)

Asymmetric information results when

managers of a firm have more information

about operations and future prospects than

do investors.

Asymmetric information can impact the firms capital

structure as follows:

On the other hand, if the outlook for the firm is poor,

management will issue equity instead since they believe/know

that the price of the firms stock is overvalued (overpriced).

Issuing equity is therefore generally thought of as a negative

signal.

Copyright 2009 Pearson Prentice

11-

In general, it is believed that the market value of a company is

maximized when the cost of capital (the firms discount rate) is

minimized.

The value of the firm can be defined algebraically as follows:

11-

Figure 11.3

Cost Functions

and Value

11-

of a Financing Plan

11-

Companys Current and Alternative Capital

Structures

11-

EPS-EBIT Approach

to Capital Structure

The EPS-EBIT approach to capital structure involves selecting

the capital structure that maximizes EPS over the expected range

of EBIT.

Using this approach, the emphasis is on maximizing the owners

returns (EPS).

A major shortcoming of this approach is the fact that earnings

are only one of the determinants of shareholder wealth

maximization.

This method does not explicitly consider the impact of risk.

Copyright 2009 Pearson Prentice

11-

EPS-EBIT Approach

to Capital Structure (cont.)

Example

EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with them.

Such calculations for three capital structuresdebt ratios of

0%, 30%, and 60%for Cooke Company were presented

earlier in Table 12.2. For EBIT values of $100,000 and

$200,000, the associated EPS values calculated are

summarized in the table with Figure 12.6.

Copyright 2009 Pearson Prentice

11-

EPS-EBIT Approach

to Capital Structure (cont.)

Figure 11.5

EBITEPS

Approach

11-

Estimates Associated with Alternative Capital

Structures for JSG Company

11-

Basic Shortcoming

of EPS-EBIT Analysis

Although EPS maximization is generally good for the

firms shareholders, the basic shortcoming of this

method is that it does not necessary maximize

shareholder wealth because it fails to consider risk.

If shareholders did not require risk premiums

(additional return) as the firm increased its use of debt,

a strategy focusing on EPS maximization would work.

Unfortunately, this is not the case.

Copyright 2009 Pearson Prentice

11-

The following discussion will attempt to create a framework

for making capital budgeting decisions that maximizes

shareholder wealthi.e., considers both risk and return.

Perhaps the best way to demonstrate this is through the

following example:

Cooke Company, using as risk measures the

coefficients of variation of EPS associated with each

of seven alternative capital structures, estimated the

associated returns as shown in Table 12.14

Copyright 2009 Pearson Prentice

11-

Capital Structure (cont.)

By substituting the level of EPS and the associated

required return into Equation 12.12, we can

estimate the per share value of the firm, P0.

11-

Capital Structure (cont.)

Figure 11.6

Estimating Value

11-

in Making Capital Structure Decisions

11-

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