Financial Management for Entrepreneurs

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Principles of Managerial FinanceBrief Edition
Chapter 12
Leverage Capital Structure
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Learning Objectives

• Discuss the role of breakeven analysis, how to
  determine the operating breakeven point, and the
  effect of changing costs on the breakeven point.
• Understand operating, financial, and total
  leverage and the relationship among them.
• Describe the basic types of capital, external
  assessment of capital structure, capital
  structure of non-U.S. firms, and capital
  structure theory.

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Learning Objectives

• Explain the optimal capital structure using a
  graphic view of the firms cost of capital
  functions and a modified form of zero-growth
  valuation model.
• Discuss the graphic presentation, risk
  considerations, and basic shortcomings of
  EBIT-EPS approach to capital structure.
• Review the return and risk of alternative capital
  structures and their linkage to market value, and
  other important capital structure considerations.

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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 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.

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Leverage Breakeven Analysis

• 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.

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

• Letting EBIT 0 and solving for Q, we get

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Leverage 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
Q FC P - VC
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Leverage Breakeven Analysis
Algebraic Approach
Algebraic Expression
Item
Sales - Variable Costs - Fixed Costs EBIT
(P x Q) - (VC x Q) - FC EBIT
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Leverage Breakeven Analysis
Algebraic Approach

• Example Omnibus Posters has fixed operating
  costs of 2,500, a sales price of 10/poster, and
  variable costs of 5/poster. Find the OBP.

Q 2,500 500 posters 10 - 5

• This implies that if Omnibus sells exactly 500
  posters, its revenues will just equal its costs
  (EBIT 0).

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Leverage Breakeven Analysis
Algebraic Approach

• 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
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Leverage Breakeven Analysis
Graphic Approach
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Leverage Breakeven Analysis
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Operating Financial Leverage
Sales - Variable Costs - Fixed Costs EBIT -
Interest EBT - Taxes Net Income
Operating Leverage and Business Risk
Total Leverage and Total Risk
Financial Leverage and Financial Risk
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Operating Financial Leverage
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Operating Financial Leverage
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.

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Operating Financial Leverage
Degree of Operating Leverage
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Operating Financial Leverage
Degree of Operating Leverage
Interval Estimate of DOL
DOL Change in EBIT 35 3.50
Change in Sales 10
Because of the presence of fixed costs in the
firms production process, a 10 increase in
Sales will result in a 35 increase in EBIT.
Note that in the absence of operating leverage
(if Fixed Costs were zero), the DOL would equal 1
and a 10 increase in Sales would result in a 10
increase in EBIT.
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Operating Financial Leverage
Degree of Operating Leverage
Point Estimate of DOL
DOL Sales - VC 700 - 420
3.50 Sales - VC - FC 700 - 420 -
200
Care must be taken when using the point estimate
because the DOL will be different at different
levels of sales. For Example, if sales increase
to 770, DOL will decline as follows
DOL Sales - VC 770 - 462
2.08 Sales - VC - FC 770 - 462 -
200
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Operating Financial Leverage
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.

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Operating Financial Leverage
Degree of Financial Leverage
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Operating Financial Leverage
Degree of Financial Leverage
Interval Estimate of DFL
DFL Change in EPS 46.67 1.33
Change in EBIT 35.00
In this case, the DFL is greater than 1 which
indicates the presence of debt financing. In
general, the greater the DFL, the greater the
financial leverage and the greater the financial
risk.
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Operating Financial Leverage
Degree of Financial Leverage
Point Estimate of DFL
DFL EBIT 80
1.33 EBIT - Interest 80 - 20
DFL EBIT 108
1.23 EBIT - Interest 108 - 20
In this case, we can see that the DFL is the same
at the expected level of EBIT. However, the DFL
declines if the firm performs better than
expected. Note also, however, that the DFL will
rise if the firm performs worse than expected.
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Operating Financial Leverage
Degree of Total Leverage
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Operating Financial Leverage
Degree of Total Leverage
Interval Estimate of DTL
DTL Change in EPS 46.7
4.67 Change in Sales 10
In this case, the DTL is greater than 1 which
indicates the presence of both fixed operating
and fixed financing costs. In general, the
greater the DTL, the greater the financial
leverage and the greater the financial risk.
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Operating Financial Leverage
Degree of Total Leverage
Point Estimate of DTL
DTL Q x (P - VC)
Q x (P-VC) - FC - I - PD/(1-t)
DTL 700 - 420
4.67 700 - 420 - 200 - 20
- 0
At our base level of sales of 700, the point
estimate gives us the same result we obtained
using the interval estimate.
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Operating Financial Leverage
Degree of Total Leverage
The relationship between the DTL, DOL, and DFL is
illustrated in the following equation
DTL DOL x DFL
Applying this to our example at a sales level of
77, we get
DTL 3.50 x 1.33 4.6
Which is the same result we obtained using either
the point or interval estimates at that sales
level.
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The Firms Capital Structure
Current Assets Fixed Assets
Current Liabilities Long-Term Debt Equity
The Firms Capital Structure
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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.

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Capital Structure Theory

• 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).

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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.

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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.

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Capital Structure Theory
Probability of Bankruptcy

• The firms 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 firms financial leverage, the
  greater will be its financial risk - the risk of
  being unable to meet its fixed interest and
  preferred stock dividends.

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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 firm
  (stockholders/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.

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Capital Structure Theory
Agency Costs Imposed by Lenders

• 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.

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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.
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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

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.
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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

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.
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Capital Structure Theory
So What is 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
  algabraeiclly as follows

V EBIT (1 - t) ka

• It can be described graphically as shown on the
  following two slides.

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Capital Structure Theory
Graphically
Ke
Cost ()
WACC
Ke
Kd
Kd
0
Target Capital Structure
TD/TA ()
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Capital Structure Theory
Graphically
Firm Value ()
V EBIT (1 - t) ka
V()
0
Target Capital Structure
TD/TA ()
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Capital Structure Theory

• An example of how this might work using actual
  numbers is demonstrated below

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Capital Structure Theory
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Debt Ratios for Selected Industries
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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.

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EPS-EBIT Approach to Capital Structure
Example The capital structure of JGS, a soft
drink manufacturer is shown in the table below.
Currently, JGS uses only equity in its capital
structure. Thus the current debt ratio is 0.00.
Assume JGS is in the 40 tax bracket.
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EPS-EBIT Approach to Capital Structure
EPS-EBIT coordinates for JSGs current capital
structure can be found by assuming two EBIT
values and calculating the associated EPS as
follows
This can be plotted on an EPS-EBIT plane as
follows
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EPS-EBIT Approach to Capital Structure
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EPS-EBIT Approach to Capital Structure
JSG is considering altering its capital structure
while maintaining its original 500,000 capital
base as shown in the table below
We can use this information to calculate the
EPS-EBIT coordinates as shown on the following
slide
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EPS-EBIT Approach to Capital Structure
This may be shown graphically as shown on the
following slide
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EPS-EBIT Approach to Capital Structure
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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.

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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

Assume that JSG is attempting to choose the best
of several alternative capital structures --
specifically, debt ratios of 0, 10, 20, 30, 40,
50, and 60 percent. Furthermore, for each of
these capital structures, the firm has estimated
EPS, the CV of EPS, and required return
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Choosing the Optimal Capital Structure
If we assume that all earnings are paid out as
dividends, we can use the zero growth valuation
model P0 EPS/ks to estimate share value as
follows
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Choosing the Optimal Capital Structure
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Other Influences on Capital Structure Choice
Flexibility
Maintaining financial flexibility simply means
that a company would like to give itself slack in
terms of being able to raise additional capital
to support working capital requirements of if
desirable investment opportunities arise.
As a result, most firms try to ensure that they
have excess borrowing capacity available by
keeping debt levels at manageable levels.
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Other Influences on Capital Structure Choice
Timing
The sale of securities by most firms depend not
only on the investment opportunities available
but also on the the cost of capital at a
particular point in time.
Successful companies usually try to forecast and
take advantage of changing market conditions to
lower their overall cost of raising funds.
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Other Influences on Capital Structure Choice
Corporate Control
Many firms avoid the issuance of new equity
because it may cause existing controlling
shareholders to lose their ability to influence
the direction of the company.
As a result, most companies are reluctant to
issue new shares of stock and instead issue debt
when additional funds are needed.
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Other Influences on Capital Structure Choice
Maturity Matching
Many firms also try to match the maturity of
their source of financing with the maturity of
the assets they are using the funds to finance.
As a result, the capital structure of a firm is
determined in part by the types of investments it
makes.
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Other Influences on Capital Structure Choice
Managements Attitude Toward Risk
Managements perception about the risk of using
debt versus equity to finance assets will also
determine the nature of a companys capital
structure.