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8/4/2019 Ch 14 Capital Structure&Leverage1
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14-1
Chapter 14:Capital Structure & Leverage
()
(Break Even Point BEP)
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=
ASSET =
Liability
Equity
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()
()
()
(rs) (beta[] )
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(Opportunity Cost)
() - EPS, ROE
dilution
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2 :
(WACC)
discount rate
(Financial
Risk)
Beta (CAPM)
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=+
=
1t
tt
)WACC1(FCFV
WACC = wd (1-T) rd + we rs
V = (value of firm) FCF = (free cash flow)
WACC = (weighted average cost of capital)
re rd(cost of stock) (Cost of debt)
we wd
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Business Risk versus Financial Risk
Business risk:.
Operation Leverage
Financial risk:
Financial Risk
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(pre-taxoperating income (EBIT)).
(business risk)
Probability
EBITE(EBIT)0
Low risk
High risk
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Business Risk
Demand (unit sales).
Sales prices.
Input cost variability.
Cost pushing
Ability to develop new product Forex risk exposure
Fixed cost
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Operation Leverage
Operating leverage
Operating leverage
Operatingleverage
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operating leverage
(More...)
Sales
$ Rev.
TC
F
QBE Sales
$ Rev.
TC
F
QBE
EBIT
}
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Probability
EBITL
Low operating leverage
High operating leverage
EBITH
Operation Leverage
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Financial Risk
Financial risk:
(Default risk)
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U L
10,000 12%
5,000 5,000 $20,000 $20,000
5,000 5,000
0 10,000 (1$) $15,000 (1$) $5,000 40% 40%
2
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Financial Leverage
$3,000 $3,000 0 1,200
$3,000 $1,800 (40%) 1 ,200 720 $1,800 $1,080
ROE 9.0% 10.8%
U L
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L
.:
U: = $1,800.
L: = $1,080 + $1,200 =$2,280.
: U: $1,200; L: $720.
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Financial Leverage
Prob. 0.25 0.50 0.25 5,000 7,000 9,000 $2,000 $3,000 $4,000 0 0 0 $2,000 $3,000 $4,000
(40%) 800 1,200 1,600 $1,200 $1,800 $2,400
Economy
Bad Avg. Good
U
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Financial Leverage
Prob.* 0.25 0.50 0.25 5,000 7,000 9,000
$2,000 $3,000 $4,000 1,200 1,200 1,200 $ 800 $1,800 $2,800 (40%) 320 720 1,120
$ 480 $1,080 $1,680
*Same as for Firm U.
Economy
Bad Avg. Good
L
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2 (Asset Management
Ratio)
(Profitability)
(Debt ManagementRatio)
Basic Earning Power (BEP)
Return on Equity (ROE)
Times Interest Earned (TIE)
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Firm U Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.
Firm L Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
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L U
Basic earning power (EBIT/TA) ROIC
(NOPAT/Capital = EBIT(1-T)/TA) Financial levergae
L ROE
L ROE Financial Leverage
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Optimal Capital Structure:
=
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(Debt
Ratios)
Debt/Equity
Debt/Asset
Interest Coverage (Times Interest Earned: TIE)
EBITDA/Interest
Current Ratio
Etc.
Policy
Rating
( )
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(Break Even)
Operating breakeven = QBE
QBE = F / (P V)
Q , F , V,TC P .
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 $10) = 40.
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(Break Even)
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120 70,000 55
1. 60, 70, 80, 90
2. 80,000 90,000