Ch' 13: Determining the Financing Mix

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Ch. 13 Determining the Financing Mix

• How do we want to finance our firms assets?

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Determining the Financing Mix

• Operating Leverage
• Financial Leverage
• Capital Structure

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2 concepts that enhance our understanding of
risk...

• 1) Operating Leverage - affects a firms business
  risk.
• 2) Financial Leverage - affects a firms
  financial risk.

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Business Risk

• The variability or uncertainty of a firms
  operating income (EBIT).

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Business Risk

• Affected by
• Sales volume variability
• Competition
• Cost variability
• Product diversification
• Product demand
• Operating Leverage

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Operating Leverage

• The use of fixed operating costs as opposed to
  variable operating costs.
• A firm with relatively high fixed operating costs
  will experience more variable operating income if
  sales change.

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Financial Risk

• The variability or uncertainty of a firms
  earnings per share (EPS) and the increased
  probability of insolvency that arises when a firm
  uses financial leverage.

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Financial Leverage

• The use of fixed-cost sources of financing (debt,
  preferred stock) rather than variable-cost
  sources (common stock).

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Breakeven Analysis

• Illustrates the effects of operating leverage.
• Useful for forecasting the profitability of a
  firm, division or product line.
• Useful for analyzing the impact of changes in
  fixed costs, variable costs, and sales price.

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Costs

• Suppose the firm has both fixed operating costs
  (administrative salaries, insurance, rent,
  property tax) and variable operating costs
  (materials, labor, energy, packaging, sales
  commissions).

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Operating Leverage

• What happens if the firm increases its fixed
  operating costs and reduces (or eliminates) its
  variable costs?

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Breakeven Calculations

• Breakeven point (units of output)
• QB breakeven level of Q.
• F total anticipated fixed costs.
• P sales price per unit.
• V variable cost per unit.

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Breakeven Calculations

• Breakeven point (sales dollars)
• S breakeven level of sales.
• F total anticipated fixed costs.
• S total sales.
• VC total variable costs.

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Degree of Operating Leverage (DOL)

• Operating leverage by using fixed operating
  costs, a small change in sales revenue is
  magnified into a larger change in operating
  income.
• This multiplier effect is called the degree of
  operating leverage.

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Degree of Operating Leveragefrom Sales Level (S)
change in EBIT change in sales
DOLs
change in EBIT EBIT change in sales
sales

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Degree of Operating Leveragefrom Sales Level (S)

• If we have the data, we can use this formula

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What does this tell us?

• If DOL 2, then a 1 increase in sales will
  result in a 2 increase in operating income
  (EBIT).

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Degree of Financial Leverage (DFL)

• Financial leverage by using fixed cost
  financing, a small change in operating income is
  magnified into a larger change in earnings per
  share.
• This multiplier effect is called the degree of
  financial leverage.

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Degree of Financial Leverage
change in EPS change in EBIT
DFL
change in EPS EPS change in EBIT
EBIT

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Degree of Financial Leverage

• If we have the data, we can use this formula

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What does this tell us?

• If DFL 3, then a 1 increase in operating
  income will result in a 3 increase in earnings
  per share.

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Degree of Combined Leverage (DCL)

• Combined leverage by using operating leverage
  and financial leverage, a small change in sales
  is magnified into a larger change in earnings per
  share.
• This multiplier effect is called the degree of
  combined leverage.

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Degree of Combined Leverage
DCL DOL x DFL
change in EPS change in Sales

change in EPS EPS change in Sales
Sales

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Degree of Combined Leverage

• If we have the data, we can use this formula

Q(P - V) Q(P - V) - F - I

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What does this tell us?

• If DCL 4, then a 1 increase in sales will
  result in a 4 increase in earnings per share.

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In-class Project

• Based on the following information on Levered
  Company, answer these questions
• 1) If sales increase by 10, what should happen
  to operating income?
• 2) If operating income increases by 10, what
  should happen to EPS?
• 3) If sales increase by 10, what should be the
  effect on EPS?

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Levered Company

• Sales (100,000 units) 1,400,000
• Variable Costs 800,000
• Fixed Costs 250,000
• Interest paid 125,000
• Tax rate 34
• Common shares outstanding 100,000

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Degree of Operating Leverage from Sales Level (S)
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Degree of Financial Leverage
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Degree of Combined Leverage
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Levered Company10 increase in sales

• Sales (110,000 units) 1,540,000
• Variable Costs (880,000)
• Fixed Costs (250,000)
• EBIT 410,000 ( 17.14)
• Interest (125,000)
• EBT 285,000
• Taxes (34) (96,900)
• Net Income 188,100
• EPS 1.881 ( 26.67)

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Chapter 13 - part 2Capital Structure

• How do we want to finance our firms assets?

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• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

Financial Structure
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• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

Capital Structure
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Why is Capital Structure Important?

• 1) Leverage higher financial leverage means
  higher returns to stockholders, but higher risk
  due to interest payments.
• 2) Cost of Capital Each source of financing
  has a different cost. Capital structure affects
  the cost of capital.
• 3) The Optimal Capital Structure is the one that
  minimizes the firms cost of capital and
  maximizes firm value.

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What is the Optimal Capital Structure?

• In a perfect world environment with no taxes,
  no transaction costs and perfectly efficient
  financial markets, capital structure does not
  matter.
• This is known as the Modigliani-Miller
  hypothesis, or the Independence Hypothesis
  firm value is independent of capital structure.

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Modigliani-Miller Hypothesis
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Modigliani-Miller Hypothesis
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kd
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Modigliani-Miller Hypothesis

• In a perfect markets environment, capital
  structure is irrelevant.
• In other words, changes in capital structure do
  not affect firm value.

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2) Moderate Position

• The previous hypothesis examines capital
  structure in a perfect market.
• The moderate position examines capital structure
  under more realistic conditions.
• For example, what happens if we include corporate
  taxes?

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Remember this example?Tax effects of financing
with debt

• with stock with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (34) (136,000) (119,000)
• EAT 264,000 231,000
• - dividends (50,000) 0
• Retained earnings 214,000
  231,000

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Moderate Position
Even if the cost of equity rises as leverage
increases, the cost of debt is very low...
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Cost of Capital
because of the tax benefit associated with debt
financing.
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financial leverage
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Moderate Position
The low cost of debt reduces the cost of
capital.
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Cost of Capital
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kd
financial leverage
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Moderate Position

• So, what does the tax benefit of debt financing
  mean for the value of the firm?
• The more debt financing used, the greater the tax
  benefit, and the greater the value of the firm.
• So, this would mean that all firms should be
  financed with 100 debt, right?
• Why are firms not financed with 100 debt?

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Why is 100 Debt not Optimal?

• Bankruptcy costs costs of financial distress.
• Financing becomes difficult to get.
• Customers leave due to uncertainty.
• Possible restructuring or liquidation costs if
  bankruptcy occurs.

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Why is 100 Debt not Optimal?

• Agency costs costs associated with protecting
  bondholders.
• Bondholders (principals) lend money to the firm
  and expect it to be invested wisely.
• Stockholders own the firm and elect the board and
  hire managers (agents).
• Bond covenants require managers to be monitored.
  The monitoring expense is an agency cost, which
  increases as debt increases.

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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Chapter 13 - part 3Capital Structure Management

• EBIT-EPS Analysis - used to help determine
  whether it would be better to finance a project
  with debt or equity.

EPS (EBIT - I)(1 - t) - P
S
I interest expense, P preferred dividends, S
number of shares of common stock outstanding.
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EBIT-EPS Example

• Our firm has 800,000 shares of common stock
  outstanding, no debt, and a marginal tax rate of
  40. We need 6,000,000 to finance a proposed
  project. We are considering two options
• Sell 200,000 shares of common stock at 30 per
  share,
• Borrow 6,000,000 by issuing 10 bonds.

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If we expect EBIT to be 2,000,000

• Financing stock debt
• EBIT 2,000,000 2,000,000
• - interest 0 (600,000)
• EBT 2,000,000 1,400,000
• - taxes (40) (800,000) (560,000)
• EAT 1,200,000 840,000
• shares outst. 1,000,000 800,000
• EPS 1.20 1.05

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If we expect EBIT to be 4,000,000

• Financing stock debt
• EBIT 4,000,000 4,000,000
• - interest 0 (600,000)
• EBT 4,000,000 3,400,000
• - taxes (40) (1,600,000) (1,360,000)
• EAT 2,400,000 2,040,000
• shares outst. 1,000,000 800,000
• EPS 2.40 2.55

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• If EBIT is 2,000,000, common stock financing is
  best.
• If EBIT is 4,000,000, debt financing is best.
• So, now we need to find a breakeven EBIT where
  neither is better than the other.

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If we choose stock financing
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If we choose bond financing
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Breakeven EBIT
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Breakeven Point

• Stock Financing Debt Financing
• (EBIT-I)(1-t) - P (EBIT-I)(1-t) - P
• S
  S
• (EBIT-0) (1-.40) (EBIT-600,000)(1-.40)
• 800,000200,000 800,000
  

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Breakeven EBIT
For EBIT up to 3 million, stock financing is
best.
For EBIT greater than 3 million, debt financing
is best.
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In-class Problem

• Plan A sell 1,200,000 shares at 10 per share
  (12 million total)
• Plan B issue 3.5 million in 9 debt and sell
  850,000 shares at 10 per share (12 million
  total)

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Breakeven EBIT

• Stock Financing Levered Financing
• (EBIT-I) (1-t) - P (EBIT-I) (1-t) - P
• S
  S
• EBIT-0 (1-.50) (EBIT-315,000)(1-.50)
• 1,200,000 850,000
• EBIT 1,080,000