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Leverage Issues
Optimal capital structure
Operating leverage Capital structure theory
Capital Structure
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Cost Of Capital ( Theoretical) It is the discount rate that that would
be used to determine the PV of aseries of future cash flows
The minimum rate of return that mustbe earned by the firm on its investment
so that its market value remainsunchanged
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The Concept of Leverage
You cannot easily move a large boulder.
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The Concept of Leverage
However, with the aid of a lever you can
move an object many times your size.
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Uncertainty about future operating income(EBIT), i.e., how well can we predict operatingincome?
Note that business risk does not includefinancing effects.
What is business risk?
Probability
EBITE(EBIT)0
Low risk
High risk
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Business risk is affectedprimarily by:
Uncertainty about demand (sales).
Uncertainty about output prices. Uncertainty about costs.
Product, other types ofliability.
Operating leverage.
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What is operating leverage, and
how does it affect a firmsbusiness risk?
Operating leverage is the use of fixedcosts rather than variable costs.
If most costs are fixed, hence do notdecline when demand falls, then the
firm has high operating leverage.
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More operating leverage leads to morebusiness risk, for then a small sales
decline causes a big profit decline.
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What is financial leverage?
Financial risk?
Financial leverage is the use of debt andstock.
Financial risk is the additional riskconcentrated on common stockholders as
a result of financial leverage.
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The Concept of Leverage In a financial context, the magnifying power
of leverage can be used to help (or hurt) a
firms financial performance. Operating leverage occurs due to fixed
costs in the production process.
With high fixed operating costs, a smallchange in sales will trigger a large changein operating income (EBIT).
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Operating Leverage
Measurement of Operating Leverage Degree of Operating Leverage (DOL)
DOL > 1 means the firm has operatingleverage.
DOL=% Change in EBIT% Change in Sales
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Operating Leverage
DOL=% Change in EBIT% Change in Sales
Example: fixed costs = Rs1 and variable costs=0
EBIT for Sales of Rs3 = Rs3 - Rs1 = Rs2
EBIT for Sales of Rs4 = Rs4 - Rs1 = Rs3
(Rs3 - Rs2)/Rs2 .50(Rs4 - Rs3)/Rs3 .33
DOL = = = 1.5
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DOL DOL = Contrb/ EBIT
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Operating Leverage
Measurement of DOL
Calculation using alternate formula:
DOL= Sales - Total VCSales -Total VC - FC
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Operating Leverage
Measurement of DOL
Calculation using alternate formula:
DOL= Sales - Total VCSales -Total VC - FC
DOL = (Rs3 - Rs0) / (Rs3 - Rs0 -
Rs1) = 1.5
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Operating Leverage
Measurement of DOL
Calculation using per unit information:
DOL= Sales - Total VCSales -Total VC - FC
Q = 3,750 unitsSP = Rs 800 per unit
VC = Rs 400 per unit
FC = Rs 1,000,000 per
year.
Example:Example:
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Operating Leverage
Measurement of DOL
Calculation using per unit information:
DOL3,750 units =
= 3
3,750(800) 3,750(400)3,750(800) 3,750(400) 1,000,000
DOL= Sales - Total VCSales-Total VC - FC
Interpretation: If sales change 1%, then
EBIT will change 3% (same direction).
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What is financial leverage?
Financial risk?
Financial leverage is the use of debt inplace of equity
Financial risk is the additional risk
concentrated on common stockholdersas a result of financial leverage.
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Financial leverage ratio definition
and explanation:
The financial leverage ratio is also
referred to as the debt to equity
ratio.
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The financial leverage ratio indicates theextent to which the business relies on debt
financing. Upper acceptable limit of the financial
leverage ratio is usually 2:1, with no morethan one-third of debt in long term.
A high financial leverage ratio indicatespossible difficulty in paying interest andprincipal while obtaining more funding.
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What Does Degree Of Financial
Leverage -DFL Mean?
A leverage ratio summarizing theaffect a particular amount of financialleverage has on a company's earnings
per share (EPS).
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Financial leverage involves using fixedcosts to finance the firm, and will
include higher expenses beforeinterest and taxes (EBIT). The higherthe degree of financial leverage, the
more volatile EPS will be, all otherthings remaining the same. Theformula is as follows:
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Financial Leverage Degree of Financial Leverage Finance a portion of the firms assets with
securities that have fixed financial costs
Debt Preferred Stock
Financial Leverage measures changes inearnings per share as EBIT changes.
DFLEBIT =% Change in NI
% Change in EBIT
Base Level of EBIT
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Degree of Financial LeverageDegree of Financial Leverage measures the amount of risk
a company takes up when it borrows more debt (andincreases the debt portionof its capital structure). The formula for Degree ofFinancial Leverage is:
Degree of Financial
Leverage
Earnings Before Interest & Taxes (EBIT)
Earnings Before Taxes (EBT)
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Financial Leverage
EBIT = Rs500,000
Interest Charges = Rs200,000
Example:
DFLEBIT=500,000 =500,000
500,000 200,000
= 1.67 times
Interpretation:When EBIT changes 1% (from
an existing level of Rs500,000) Net Income
will change 1.67% in the same direction.
The formula is as follows:
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Financial LeverageEBIT = Rs500,000
Interest Charges = Rs200,000
Example:
DFLEBIT=500,000 =500,000
500,000 200,000
= 1.67 times
Interpretation:When EBIT changes 1% (from
an existing level of Rs500,000) Net Income
will change 1.67% in the same direction.
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To illustrate Degree of Financial Leverage,lets do a hypothetical question
. Imagine there are 3 firms, Firm A, Firm Band Firm C. Each one has an interest
expense of $12000 in the year 2006. TheEarnings Before Taxes for each firm is givenbelow in the table. Can you calculate theDegree of Financial Leverage using this
data? Interest Expense = $80,000 x 15% = $12000
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Firm A Firm B Firm C
EBIT 25000 50000 75000
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Firm A Firm B Firm C
EBIT 25000 50000 75000
EBT (EBIT -
Interest
Expense)
25000 -
12000
= 13000
50000 -
12000
= 38000
75000 -
12000
= 63000
Degree of
FinancialLeverage
(EBIT /
EBT)
25000 /13000
= 1.92
50000 /38000
= 1.32
75000 /63000
= 1.19
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Future returns based onprobability
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A practical illustration
Supposing elections are to be held in a short
time and an analyst pictures the followingthree scenarios
1) Scenario 1 with a probability of 025%
A stable government with majority ruleA rate of return is forecasted to be around
36%
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2) Scenario 2 with a probability of
0.50%
A coalition government lasting its
full term.
A rate of return is forecasted to be
around 26%
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3) Scenario 3 with a probability of
0.25%
Re-elections in the immediate
future.
A rate of return is forecasted to be
around 12%
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This three scenarios will coverallpossible situations and hence the
total of all the probabilities will be 1meaning there cannot be anotherpossible situation.
We put the information in the form of atable
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Scenario Probability ExpectedReturn
1 0.25 36%
2 0.50 26%
3 0.25 12%
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Now an investor will ask a very simplequestion considering all the possible
situations and values involved whatwould be my average expected
return?
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The expected average return is nothingbut the weighted average return of all
the returns and where the weights arethe respective probabilities.
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Scenario Probability ExpectedReturn
Average
1 0.25 36% (.25*36) =9
2 0.50 26% (.50*26)=13
3 0.25 12% (.25*12)=3
9+13+3=25%
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Given a probability distribution of returns, the expected returncan be calculated using the following equation:
where
E[R] = the expected return on the stock,
N = the number of states,
pi = the probability of state i, and
Ri = the return on the stock in state i.
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Risk
Given an asset's expected return, itsvariance can be calculated using the
following equation:
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where
N = the number of states,
pi = the probability of state i,
Ri = the return on the stock in state i,and
E[R] = the expected return on thestock.
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The standard deviation is calculated asthe positive square root of the
variance.
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Indifference EBIT Example
ABC Corp. currently has 200,000shares outstanding on the stock market
with the current price being $20. TheBoard of Directors of the Corp want toincur a debt of $1 million by issuing junk
bonds that have a coupon interest rateof 9% annually. At what point of EBITwould the Corp. be indifferent to havingdebt or NO debt?
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Current Capital Structure = $20 x200,000 shares = $4,000,000 Equity
New Capital Structure = $3,000,000Equity & $1,000,000 Debt
- Current Stock Price Remains at $20.
- To attain $3,000,000 of Equity, the # ofshares = 150,000.
Annual Interest Expense Coupon
Payments = 9% x 1,000,000 = $90,000S N Tara 55
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No Debt With Debt
Indifference EBITEBIT - 0
200,000
= EBIT - 90,000
150,000
Indifference EBIT
150,000 EBIT = 200,000 (EBIT - 90,000)
150,000 EBIT = 200000EBIT - 18000000000
18000000000= 200,000 EBIT - 150,000 EBIT18000000000= 50,000 EBIT
EBIT = 18000000000 / 50,000
EBIT = $360,000
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Interpretation of EBIT
At a point where Earnings Before
Interest & Taxes is $360,000, ABCCorp. will not care whether it has anyoutstanding debt issues, NO debt or a
combination of both because at thispoint, the value of the Capital Structureis NOT affected.
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Why does the bond rating and
cost of debt depend upon theamount borrowed?
As the firm borrows more money, thefirm increases its risk causing the
firms bond rating to decrease, and its
cost of debt to increase.
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Other factors to consider when
establishing the firms targetcapital structure?
1. Industry average debt ratio
2. TIE ratios under different scenarios3. Lender/rating agency attitudes
4. Reserve borrowing capacity
5. Effects of financing on control6. Asset structure
7. Expected tax rate
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Financial Leverage of Ten Largest Indian
Companies, 2006
Company Capital Gearing Income Gearing
Debt ratio Debtequity ratio Interest coverage Interest to EBIT ratio
1. Indian Oil 0.556 1.25:1 4.00 0.250
2. HPCL 0.350 0.54:1 5.15 0.194
3. BPCL 0.490 0.96:1 5.38 0.186
4. SAIL 0.858 6.00:1 - ve - ve
5. ONGC 0.106 0.12:1 53.49 0.019
6. TELCO 0.484 0.94:1 0.99 1.007
7. TISCO 0.577 1.37:1 1.62 0.616
8. BHEL 0.132 0.15:1 8.36 0.120
9. Reliance 0.430 0.75:1 3.46 0.289
10. L&T 0.522 1.09:1 2.31 0.433
11. HLL 0.027 0.03:1 264.92 0.004
12. Infosys 0.000 0.00:1 NA* NA*
13. Voltas 0.430 0.72:1 2.64 0.378
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Three commonly used ratios for
analyzing leverage are debt to assets,
long term debt to equity and timesinterest earned. These ratios should
be of interest to both creditors andmembers.
Note
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Times interest earned (TIE) is
calculated by dividing earnings beforeinterest and taxes by interest
payments. Creditors want to know if
the organisations operations generate
enough margins to cover the interestpayments.
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Long-term Debt Ratios for
Selected Industries
Industry Long-Term Debt RatioPharmaceuticals 20.00%Computers 25.93Steel 39.76Aerospace 43.18Airlines 56.33
Utilities 56.52
Source: Dow Jones News Retrieval. Datacollected through December 17, 1999.
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net earnings:
Gross sales minus taxes, interest,depreciation, and other expenses.Net earnings are one of the most importantmeasures of a company's
performance, since the pursuit of earnings isthe primary reasoncompanies exist. Sometimes net earningsincludes one-time and
extraordinary items, and sometimes it doesnot. also called netearnings or net income orbottom line.