1. Chapter 12 Leverage and Capital Structure Reporters: Jasmin C. Raymundo Mary Ann Bosogon Copyright 2009 Pearson Prentice Hall. All rights reserved.

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. Describe the basic types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory.

3. 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.

4. 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.

5. Leverage (cont.) Table 12.1 General Income Statement Format and Types of Leverage

6. 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 firms 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.

7. 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.

8. Breakeven Analysis: Algebraic Approach Using the following variables, the operating portion of a firms income statement may be recast as follows: P = sales price per unit Q = sales quantity in units FC = fixed operating costs per period VC = variable operating costs per unit Letting EBIT = 0 and solving for Q, we get: EBIT = (P x Q) - FC - (VC x Q)

9. Breakeven Analysis: Algebraic Approach (cont.)

10. Breakeven Analysis: Algebraic Approach (cont.) Table 12.2 Operating Leverage, Costs, and Breakeven 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 = Q = $2,500 = 500 posters $2,500 = 500 posters $10 - $5 $10 - $5 This implies that if Cheryls sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).

12. 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) EBIT = $5,000 - $2,500 - $2,500 = $0

13. Breakeven Analysis: Graphical Approach Figure 12.1 Breakeven Analysis

14. Breakeven Analysis: Changing Costs and the Operating Breakeven Point Assume that Cheryls 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.

15. 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

16. Breakeven Analysis: Changing Costs and the Operating Breakeven Point Table 12.3 Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables

17. Operating Leverage Figure 12.2 Operating Leverage

18. Operating Leverage (cont.) Table 12.4 The EBIT for Various Sales Levels

19. 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 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.

20. 1. Operating breakeven point = $3,000 = 600 units $10 - $5 2.Operating breakeven point = $2,500 = 333 1/3 units $12.50 - $5 3.Operating breakeven point = $2,500 = $10 - $7.50 1,000 units 4. Operating breakeven point = $3,000 = 600 units $12.50 - $7.50

21. Operating Leverage: Measuring the Degree of Operating Leverage (cont) DOL = Percentage change in EBIT Percentage change in Sales Applying this equation to cases 1 and 2 in Table 12.4 yields: Case 1: DOL = (+100% +50%) = 2.0 Case 2: DOL = (-100% -50%) = 2.0

22. 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. 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

23. Operating Leverage: Fixed Costs 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 = 1,000 X ($10 - $4.50) 1,000 X ($10 - $4.50) - $2,500 = 2.2

24. Operating Leverage: Fixed Costs and Operating Leverage (cont.) Table 12.5 Operating Leverage and Increased Fixed Costs

25. 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.

26. Financial Leverage (cont.) 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).

27. Financial Leverage (cont.) Table 12.6 The EPS for Various EBIT Levelsa

28. 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.

29. Financial Leverage: Measuring the Degree of Financial Leverage (cont) DFL = Percentage change in EPS Percentage change in EBIT Applying this equation to cases 1 and 2 in Table 12.6 yields: Case 1: DFL = (+100% +40%) = 2.5 Case 2: DFL = (-100% -40%) = 2.5

30. Financial Leverage: Measuring the 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)] 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

31. 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.

32. Total Leverage (cont.) 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.

33. Total Leverage: Measuring the Degree of Total Leverage DTL = Percentage change in EPS Percentage change in Sales Applying this equation to the data Table 12.7 yields: Degree of Total Leverage (DTL) = (300% 50%) = 6.0

34. Total Leverage: Measuring the 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)] 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 = 20,000 X ($5 $2) 20,000 X ($5 $2) $10,000 $20,000 [$12,000 x 1/(1-.4)] DTL at 20,000 units = $60,000/$10,000 = 6.0

35. Total Leverage: The Relationship of Operating, Financial and Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL Applying this to our previous example we get: DTL = 1.2 X 5.0 = 6.0

36. Total Leverage (cont.) Table 12.7 The Total Leverage Effect

37. The Firms 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.

38. Types of Capital

39. 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 firms optimal capital structure might be. Theoretically, however, a firms optimal capital structure will just balance the benefits of debt financing against its costs.

40. Capital Structure Theory (cont.) 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).

41. 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.

42. Capital Structure Theory: 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.

43. Capital Structure Theory: 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.

44. Capital Structure Theory: Probability of Bankruptcy (cont.) Business Risk Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and EBIT from its forecasting group as show in Table 12.9. Table 12.9 Sales and Associated EBIT Calculations for Cooke Company ($000)

45. Capital Structure Theory: Probability of Bankruptcy (cont.) Business Risk When developing the firms capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firms operating leverage, sales revenue variability, and cost predictability.

46. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Let us assume that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity, and (3) the total amount of capital remains constant at $500,000, the mix of debt and equity associated with various debt ratios would be as shown in Table 12.10.

47. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.10 Capital Structures Associated with Alternative Debt Ratios for Cooke Company

48. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.11 Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Companys Alternative Capital Structures

49. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.)

50. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.)

51. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.12 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

52. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Table 12.13 Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative Capital Structures for Cooke Company

53. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Figure 12.3 Probability Distributions

54. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk Figure 12.4 Expected EPS and Coefficient of Variation of EPS

55. Capital Structure Theory: Agency Costs 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.

56. Capital Structure Theory: Agency Costs 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.

57. Capital Structure Theory: 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.

58. Capital Structure Theory: 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.

59. Capital Structure Theory: 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.

60. The Optimal Capital Structure 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:

61. The Optimal Capital Structure Figure 12.5 Cost Functions and Value

62. 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.

63. 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.

64. EPS-EBIT Approach to Capital Structure (cont.) Figure 12.6 EBITEPS Approach

65. 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.

66. Choosing the Optimal Capital Structure 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: Coke 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

67. Choosing the Optimal Capital Structure (cont.) Table 12.14 Required Returns for Cooke Companys Alternative Capital Structures

68. Choosing the Optimal 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.

69. Choosing the Optimal Capital Structure (cont.) Table 12.15 Calculation of Share Value Estimates Associated with Alternative Capital Structures for Cooke Company

70. Choosing the Optimal Capital Structure (cont.) Figure 12.7 Estimating Value

71. Table 12.16 Important Factors to Consider in Making Capital Structure Decisions