CHAPTER 11 and 14

LEVERAGE AND CAPITAL STRUCTURE

• Risk – the likely variability associated with expected revenue streams.

• The variations in the income stream can be attributed to:

a. The firm’s exposure to business riskb. The firm’s decision to incur financial risk

• Business Risk – the risk that comes from the nature of the firm’s operating activities.

• Financial Risk – the risk that comes from the financial policy (i.e capital structure) of the firm.

2SITI AISHAH BINTI KASSIM (FM2)

• Financial Leverage – the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

• Operating Leverage – the incurrence of fixed operating costs in the firm’s income stream.


• Objective – to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit. • The break-even quantity of output results in an EBIT

level = 0• Some actual and potential applications of BEP include:

a. Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models.

b. Pricing policyc. Labor contract negotiationsd. Evaluation of cost structuree. Financial decision making


• Essential elements of the break-even model:1. Fixed cost – cost that do not vary in total amount as the sales

volume or the quantity of output changes. Examples:a. Administrative salariesb. Depreciationc. Insurance premiumsd. Property taxese. Rent

2. Variable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples:

a. Direct materialsb. Direct Laborc. Energy cost associated with productiond. Packaginge. Freight-outf. Sales commissions


3. Semivariables costs (Semifixed cost) – cost that exhibit the joint characteristics of both FC and VC over different ranges of output. Examples: Salaries paid to production supervisors.


• The break-even is just a simple adaptation of the firm’s income statement expressed as:– Profit (π) = Sales – (Total VC + Total FC)

• 3 ways to find BEP:a. Trial and Error

1) Select an arbitrary output level

2) Calculate the corresponding EBIT amount

3) When EBIT = 0, BEP has been found.


b. Contribution Margin Analysis1) Contribution Margin = Unit Selling Price – Unit VC2) BEP (units) = FC

contribution margin per unit

c. Algebraic Analysis1) QB = the break-even level of units

soldP = the unit sales priceF = the total FC for the periodV = unit VC

2) Then, QB = F

P – V 8SITI AISHAH BINTI KASSIM (FM2)

Example:

Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360,000, how many dress must MC sell to breakeven?


Solutions:

*unit variable cost (VC) = 70% x RM 30 = RM 21

QB = F

P – V

= RM 360 000 = 40 000 unit

RM 30 – RM 21


• The BEP in sales dollars:– S* = F

1 – VC

S

Example: Sales $ 300 000

(-) Total VC 180 000

Revenue before FC 120 000

(-) Total FC 100 000

EBIT $ 20 000


Solutions:

S* = F = $ 100 0001 – VC 1 – $ 180 000

S $ 300 000

= $ 100 000

1 – 0.60

= $ 250 000


• Degree of Operating Leverage from the base = % change in EBIT sales level (DOLs) % change in Sales

• DOLs = Q (P – V) Q (P – V) – F

• DOLs = revenue before FC = S – VC EBIT S – VC – F


Example:Avitar Corporation manufactures a line of computer memory expansion boards used in microcomputers. The average selling price of its finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650,000 per year. Avitar estimates the sales in next year will be 20,000 units. What is Avitar expected degree of operating leverage?


Solutions:

DOLs = Q (P – V)

Q (P – V) – F

= 20 000 ($ 175 – $ 115)

[20 000 ($ 175 – $ 115)] – $ 650 000

= 2.1818 times15SITI AISHAH BINTI KASSIM (FM2)

• DFL = % change in EPS > 1

% change in EBIT

• DFLEBIT = EBIT

EBIT – I

* I = interest expense


Example:Sales $ 600,000

(-) total VC $ 200,000Revenue before FC $ 400,000

(-) total FC $ 200,000EBIT $ 200,000

(-) interest expenses $ 50,000EBT $ 150,000Taxes (34%) $ 51,000Net Income (EAT) $ 99,000


Solutions:What is the degree of financial leverage?

DFLEBIT = EBIT EBIT – I

= $ 200 000 $ 200 000 – $ 50 000

= 1.33 times


• DCL = % change in EPS

% change in Sales

• DCLs = (DOLs) x (DFLEBIT)

• DCLs = Q (P – V)

Q (P – V) – F – I


• Financial Structure – the mix of all funds source that appear on the right side of the balance sheet.

• Capital Structure – the mix of long term sources of funds used by the firm. Basically, this concept omits short-term liabilities.

• Financial Structure Design – the management activity of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds.

• Optimal Capital Structure – the unique capital structure that minimizes the firm’s composite cost of long term capital.


1. EBIT-EPS indifference point – the level of EBIT that will equate EPS between two difference financing plans.

EPS: Stock Plan EPS: Bond Plan

(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P

Ss Sb

* EBIT = earning before interest and taxes

I = interest expenses

t = firm income tax rate

P = preferred dividend paid

Ss = the number of common s/o under the stock plan

Sb = the number of common s/o under the bond plan


2. Projected Income StatementAlternative 1 Alternative 2

EBIT XXXXXX XXXXXX (-) Interest XXXXX XXXXX

EBT XXXXXX XXXXXX (-) Taxes XXXXX XXXXX

Net Income XXXXXX XXXXXXShares XXXXXXX XXXXXXXEPS* XXX XXX

*EPS = Net Income Shares Outstanding


Example:ING Berhad is financed entirely with 800,000 shares of common stock priced at RM 5 per unit and RM 1,000,000 worth of debt (8% 10 years bond). The company plans to raise an additional RM 2,000,000 to finance new project and considering two alternatives;

Alternative 1: 200,000 new common shares sold to the public

Alternative 2: Issue 10% bond

Projected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.


Solutions:i. Calculate the indifference level of EBIT between two

alternatives.

* Plan Stock (alternative 1)

= Interest on bond = (1,000,000 x 8% = RM 80,000)

Unit shares = 800,000 + 200,000 = 1,000,000

*Plan Bond (alternative 2)

= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)

Unit shares = 800,000


Plan Stock Plan Bond

(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P

Ss Sb

(EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0

1,000,000 800,000

0.72 EBIT – RM 57,600 = 0.72 EBIT – RM 201,600

1,000,000 800,000

576,000 EBIT – RM 46,080,000,000 = 720,000 EBIT – RM 201,600,000,000

– 144,000 EBIT = – RM 155,520,000,000

EBIT = RM 1,080,000


ii. Prepare the projected income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in question (i)

Alternative 1 Alternative 2

EBIT RM 1,080,000 RM 1,080,000

(-) Interest 80,000 280,000

EBT 1,000,000 800,000

(-) Taxes (28%) 280,000 224,000

Net Income 720,000 576,000

Shares 1,000,000 800,000

EPS* 0.72 0.72

*EPS = Net Income

Shares Outstanding


iii. Which plan will provide the highest EPS for the EBIT projected level?

Alternative 1 Alternative 2

EBIT RM 2,000,000 RM 2,000,000

(-) Interest 80,000 280,000

EBT 1,920,000 1,720,000

(-) Taxes (28%) 537,600 481,600

Net Income 1,382,400 1,238,400

Shares 1,000,000 800,000

EPS* 1.3824 1.548

*EPS = Net Income

Shares Outstanding


SITI AISHAH BINTI KASSIM (FM2) 29

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CHAPTER 11 and 14

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