Leverage and Capital Structure week 10 and 11

Learning Goals

1. Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on it.

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

Learning Goals

4. Explain the optimal capital structure using a graphical view of the firm’s cost of capital functions and a zero- growth valuation model.

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.

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 Types

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

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.
Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Breakeven Analysis: Algebraic Approach

Using the following variables, the operating portion of a firm’s 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

_{Copyright © 2009 Pearson Prentice Hall. All rights reserved.}

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

Breakeven Analysis: Algebraic Approach (cont.)

Table 12.2 Operating Leverage, Costs, and Breakeven

Analysis Breakeven Analysis: Algebraic Approach (cont.)

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.

Q = $2,500 = 500 posters $10 - $5

This implies that if Cheryl’s sells exactly 500

posters, its revenues will just equal its costs _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.}

(EBIT = $0).

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

Breakeven Analysis: Algebraic Approach (cont.)

Breakeven Analysis: Graphical Approach

Figure 12.1 Breakeven Analysis Copyright © 2009 Pearson Prentice Hall. All rights reserved. Breakeven Analysis: Changing Costs and the Operating Breakeven Point 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

Breakeven Analysis: Changing Costs and the Operating Breakeven Point

Table 12.3 Sensitivity of Operating Breakeven Point

to Increases in Key Breakeven Variables Operating Leverage

Figure 12.2

Operating Leverage (cont.)

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.

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

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)

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 Operating Leverage: Measuring the Degree of Operating Leverage (cont) Operating Leverage: Fixed Costs and Operating Leverage 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 _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.} 1,000 X ($10 - $4.50) - $2,500 Operating Leverage: Fixed Costs and Operating Leverage (cont.)

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.

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 _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.} $2,400 ($4/share x 600 shares). Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Financial Leverage (cont.)

Table 12.6 The EPS for Various EBIT Levels a 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.

Applying this equation to cases 1 and 2 in Table
12.6 yields: Financial Leverage: Measuring the Degree of Financial Leverage (cont)

DFL = Percentage change in EPS Percentage change in EBIT Case 1: DFL = (+100% ÷ +40%) = 2.5 Case 2: DFL = (-100% ÷ -40%) = 2.5 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)] _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.} DFL at $10,000 EBIT = 2.5 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.

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.

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:

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)] _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.} DTL at 20,000 units = $60,000/$10,000 = 6.0 Copyright © 2009 Pearson Prentice Hall. All rights reserved.

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.)

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

External Assessment of Capital Structure

Table 12.8 Debt Ratios for Selected Industries and Lines of Business

Capital Structure of Non-U.S. Firms

In recent years, researchers have focused attention not

only on the capital structures of U.S. firms, but on the capital structures of foreign firms as well. In general, non-U.S. companies have much higher
degrees of indebtedness than their U.S. counterparts. In most European and Pacific Rim countries, large
commercial banks are more actively involved in the financing of corporate activity than has been true in the U.S.

Capital Structure of Non-U.S. Firms (cont.)

Furthermore, banks in these countries are permitted to make

large equity investments in non-financial corporations—a practice forbidden in the U.S. However, similarities also exist between U.S. firms and their
foreign counterparts.
For example, the same industry patterns of capital structure tend
to be found around the world. In addition, the capital structures of U.S.-based MNCs tend to be
similar to those of foreign-based MNCs.

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.

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 firm’s
– actions, and the costs associated with the firm’s managers having more
–
information about the firm’s prospects than do investors
_{Copyright © 2009 Pearson Prentice Hall. All rights reserved.}

(asymmetric information). 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.

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.

Capital Structure Theory: Probability of Bankruptcy (cont.) Business Risk

When developing the firm’s 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 firm’s operating leverage, sales revenue variability, and cost predictability.

Capital Structure Theory: Probability of Bankruptcy (cont.)

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 _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.}

Financial Risk

various debt ratios would be as shown in Table 12.10. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

Table 12.10

Capital Structures Associated with Alternative Debt Ratios for Cooke Company Copyright © 2009 Pearson Prentice Hall. All rights reserved. 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 Company’s Alternative Capital Structures Copyright © 2009 Pearson Prentice Hall. All rights reserved. Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

Table 12.12

Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.)

Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

Table 12.12

Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company (cont.)

Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

Table 12.12

Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

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

Financial Risk

Capital Structure Theory: Probability of Bankruptcy (cont.)

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

Figure 12.4 Expected EPS and Coefficient of Variation

When a firm borrows funds by issuing debt, the interest

rate charged by lenders is based on the lender’s assessment of the risk of the firm’s investments. After obtaining the loan, the firm’s 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 firm’s bondholders are locked in and are unable to share in this success.

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.

Capital Structure Theory: Agency Costs Imposed by Lenders (cont.)

Asymmetric information results when managers of a
Asymmetric information can impact the firm’s 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.

Capital Structure Theory: Asymmetric Information

firm have more information about operations and future prospects than do investors.

Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors.
Asymmetric information can impact the firm’s 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 firm’s prospects.

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 firm’s 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 firm’s stock is overvalued (overpriced).

Issuing equity is therefore generally thought of as a “negative”

signal.

The Optimal Capital Structure In general, it is believed that the market value of a company is

maximized when the cost of capital (the firm’s discount rate) is
minimized. The value of the firm can be defined algebraically as follows:

The Optimal Capital Structure

Figure 12.5

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.

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 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.)

Figure 12.6

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.

Choosing the Optimal Capital Structure

The following discussion will attempt to create a

framework for making capital budgeting decisions that maximizes shareholder wealth—i.e., considers both risk and return. Perhaps the best way to demonstrate this is through the
following example:

Cooke Company, using as risk measures the coefficients of variation of EPS associated with each of seven alternative capital structures, estimated the _{Copyright © 2009 Pearson Prentice Hall. All rights reserved.} associated returns as shown in Table 12.14 Choosing the Optimal Capital Structure (cont.)

Table 12.14 Required Returns for Cooke Company’s

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, P .

Choosing the Optimal Capital Structure (cont.)

Table 12.15 Calculation of Share Value Estimates

Associated with Alternative Capital Structures for Cooke Company Copyright © 2009 Pearson Prentice Hall. All rights reserved. Choosing the Optimal Capital Structure (cont.) Figure 12.7 Estimating Value Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Table 12.16 Important Factors to Consider

Leverage and Capital Structure week 10 and 11

Learning Goals

Learning Goals

Breakeven Analysis (cont.)

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

Q = $2,500 = 500 posters $10 - $5

Figure 12.2

Financial Leverage (cont.)

Capital Structure of Non-U.S. Firms (cont.)

Capital Structure Theory: Probability of Bankruptcy

Financial Risk

Capital Structure Theory: Asymmetric Information (cont.)

Figure 12.5

EPS-EBIT Approach to Capital Structure (cont.)

Figure 12.6

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Leverage and Capital Structure week 10 and 11

Learning Goals

Learning Goals

Breakeven Analysis (cont.)

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

Q = $2,500 = 500 posters $10 - $5

Figure 12.2

Financial Leverage (cont.)

Capital Structure of Non-U.S. Firms (cont.)

Capital Structure Theory: Probability of Bankruptcy

Financial Risk

Capital Structure Theory: Asymmetric Information (cont.)

Figure 12.5

EPS-EBIT Approach to Capital Structure (cont.)

Figure 12.6

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