Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 7 Leverage and Capital...

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 7Leverage and Capital Structure

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-2

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. Discuss the EBIT-EPS approach to capital structure.


Leverage

• Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s 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 firm’s capital structure—the mix of debt and equity—can significantly affect its value by affecting risk and return.


Leverage (cont.)

Table 12.1 General Income Statement Format and Typesof Leverage


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.

• The firm’s operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses.

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


Breakeven Analysis (cont.)

• 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.


P = sales price per unit

Q = sales quantity in units

FC = fixed operating costs per period

VC = variable operating costs per unit

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

Breakeven Analysis: Algebraic Approach

• Letting EBIT = 0 and solving for Q, we get:

Using the following variables, the operating portion of a firm’s income statement may be recast as follows:


Breakeven Analysis: Algebraic Approach (cont.)



Table 12.2 Operating Leverage, Costs, and Breakeven Analysis


Q = $2,500 = 500 posters

$10 - $5


• This implies that if Cheryl’s sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).

Example: Cheryl’s 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.


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

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

EBIT = $5,000 - $2,500 - $2,500 = $0


• We can check to verify that this is the case by substituting as follows:


Breakeven Analysis: Graphical Approach

Figure 12.1 Breakeven Analysis


Assume that Cheryl’s Posters wishes to evaluate the impact

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.

Breakeven Analysis: Changing Costs 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




Table 12.3 Sensitivity of Operating Breakeven Pointto Increases in Key Breakeven Variables


Operating Leverage

Figure 12.2 Operating Leverage


Operating Leverage (cont.)

Table 12.4 The EBIT for Various Sales Levels


Operating Leverage: Measuring the Degree of Operating Leverage

• The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales.

• A company’s 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.


DOL = Percentage change in EBIT

Percentage change in Sales

Case 1: DOL = (+100% ÷ +50%) = 2.0

Case 2: DOL = (-100% ÷ -50%) = 2.0

Operating Leverage: Measuring the Degree of Operating Leverage (cont)

• Applying this equation to cases 1 and 2 in Table 12.4 yields:


DOL at base Sales level Q = Q X (P – VC) Q X (P – VC) – FC

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 yields the following result:

DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0 1,000 X ($10 - $5) - $2,500

Operating Leverage: Measuring the Degree of Operating Leverage (cont)

• A more direct formula for calculating DOL at a base sales level, Q, is shown below.


Assume that Cheryl’s 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 = 1,000 X ($10 - $4.50) = 2.2 1,000 X ($10 - $4.50) - $2,500

Operating Leverage: Fixed Costs and Operating Leverage


Operating Leverage: Fixed Costs and Operating Leverage (cont.)

Table 12.5 Operating Leverage and Increased Fixed Costs


Financial Leverage

• Financial leverage results from the presence of fixed financial costs in the firm’s 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 firm’s EPS.

• The two fixed financial costs most commonly found on the firm’s income statement are (1) interest on debt and (2) preferred stock dividends.


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).

Financial Leverage (cont.)


Financial Leverage (cont.)

Table 12.6 The EPS for Various EBIT Levelsa


Financial Leverage: Measuring the 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.


DFL = Percentage change in EPS

Percentage change in EBIT

Case 1: DFL = (+100% ÷ +40%) = 2.5

Case 2: DFL = (-100% ÷ -40%) = 2.5

• Applying this equation to cases 1 and 2 in Table 12.6 yields:

Financial Leverage: Measuring the Degree of Financial Leverage (cont)


DFL at base level EBIT = EBIT EBIT – I – [PD x 1/(1-T)]

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and 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

• A more direct formula for calculating DFL at a base level of EBIT is shown below.

Financial Leverage: Measuring the Degree of Financial Leverage (cont)


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 firm’s earnings per share.

• Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure.


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.

Total Leverage (cont.)


DTL = Percentage change in EPS

Percentage change in Sales

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

Total Leverage: Measuring the Degree of Total Leverage

• Applying this equation to the data Table 12.7 yields:


DTL at base sales level = Q x (P – VC) Q x (P – VC) – FC – I – [PD x 1/(1-T)]

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and the tax rate, T = 40% yields the following result:

DTL at 20,000 units = $60,000/$10,000 = 6.0

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)]

• A more direct formula for calculating DTL at a base level of Sales, Q, is shown below.

Total Leverage: Measuring the Degree of Total Leverage (cont.)


DTL = DOL x DFL

The relationship between the DTL, DOL, and DFL is illustrated

in the following equation:

DTL = 1.2 X 5.0 = 6.0

Applying this to our previous example we get:

Total Leverage: The Relationship of Operating, Financial and Total Leverage


Total Leverage (cont.)

Table 12.7 The Total Leverage Effect


The Firm’s Capital Structure

• 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.


Types of Capital


Capital Structure Theory

• 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 firm’s optimal capital structure might be.

• Theoretically, however, a firm’s optimal capital structure will just balance the benefits of debt financing against its costs.


• 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 firm’s

actions, and– the costs associated with the firm’s managers having more

information about the firm’s prospects than do investors (asymmetric information).

Capital Structure Theory (cont.)


Capital Structure Theory: 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.


Capital Structure Theory: Probability of Bankruptcy

• The probability that debt obligations will lead to bankruptcy depends on the level of a company’s 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 firm’s fixed costs relative to variable costs, the greater the firm’s operating leverage and business risk.

• Business risk is also affected by revenue and cost stability.


Capital Structure Theory: Probability of Bankruptcy (cont.)

• The firm’s capital structure—the mix between debt versus equity—directly 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 firm’s financial leverage, the greater will be its financial risk—the risk of being unable to meet its fixed interest and preferred stock dividends.


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.


Example

EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with them.

Such calculations for three capital structures—debt 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.

EPS-EBIT Approach to Capital Structure (cont.)


EPS-EBIT Approach to Capital Structure (cont.)

Figure 12.6EBIT–EPS Approach


Basic Shortcoming of EPS-EBIT Analysis

• Although EPS maximization is generally good for the firm’s 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.

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Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 7 Leverage and Capital...

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