Download Financial Management for Entrepreneurs

Chapter 11
Leverage and
Capital Structure
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.
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11-2
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.
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.
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11-3
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.
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11-4
Leverage (cont.)
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11-5
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.
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11-6
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.
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11-7
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
• Letting EBIT = 0 and solving for Q, we get:
EBIT = (P x Q) - FC - (VC x Q)
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11-8
Breakeven Analysis:
Algebraic Approach (cont.)
Q =
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FC
P - VC
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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
(EBIT = $0).
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11-10
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
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11-11
Breakeven Analysis:
Graphical Approach
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11-12
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.
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11-13
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
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11-14
Breakeven Analysis: Changing Costs
and the Operating Breakeven Point
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11-15
Operating Leverage
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11-16
Operating Leverage (cont.)
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11-17
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.
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11-18
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
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11-19
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
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11-20
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
1,000 X ($10 - $4.50) - $2,500
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11-21
Operating Leverage: Fixed Costs
and Operating Leverage (cont.)
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11-22
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.
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11-23
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).
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11-24
Financial Leverage (cont.)
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11-25
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.
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11-26
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
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11-27
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 =
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2.5
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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.
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11-29
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.
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11-30
Total Leverage (cont.)
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11-31
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
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11-32
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
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11-33
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
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11-34
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.
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11-35
Types of Capital
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11-36
External
Assessment
of Capital
Structure
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11-37
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.
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11-38
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.
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11-39
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 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.
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11-40
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 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).
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11-41
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.
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11-42
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.
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11-43
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.
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11-44
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.
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11-45
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.
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11-46
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.
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11-47
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-48
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-49
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-50
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-51
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-52
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-53
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-54
Capital Structure Theory:
Probability of Bankruptcy (cont.)
• Financial Risk
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11-55
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 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.
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11-56
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.
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11-57
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 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.
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11-58
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 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.
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11-59
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 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.
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11-60
The Optimal Capital Structure
• In general, it is believed that the market value of a
company is maximized when the cost of capital (the
firm’s discount rate) is minimized.
• The value of the firm can be defined algebraically
as follows:
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11-61
The Optimal Capital Structure
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11-62
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.
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11-63
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 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.
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11-64
EPS-EBIT Approach
to Capital Structure (cont.)
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11-65
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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11-66
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
associated returns as shown in Table 12.14
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11-67
Choosing the Optimal
Capital Structure (cont.)
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11-68
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.
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11-69
Choosing the Optimal
Capital Structure (cont.)
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11-70
Choosing the Optimal
Capital Structure (cont.)
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11-71
Insert Table 12.16 here
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11-72