Download financial leverage

Chapter 11
Leverage
and Capital
Structure
Copyright © 2009 Pearson Prentice Hall. All rights reserved.
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. .
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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 zerogrowth valuation model.
5. .
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.)
Table 11.1 General Income Statement Format and Types
of Leverage
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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.)
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11-9
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:
Graphical Approach
Figure 11.1 Breakeven Analysis
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11-11
Operating Leverage (cont.)
Table 11.4 The EBIT for Various Sales Levels
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11-12
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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11-13
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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11-14
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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11-15
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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11-16
Operating Leverage: Fixed Costs
and Operating Leverage (cont.)
Table 11.5 Operating Leverage and Increased Fixed Costs
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11-17
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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11-18
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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11-19
Financial Leverage (cont.)
Table 11.6 The EPS for Various EBIT Levelsa
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11-20
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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11-21
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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11-22
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
11-23
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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11-24
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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11-25
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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11-26
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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11-27
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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11-28
Total Leverage (cont.)
Table 11.7 The Total Leverage Effect
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11-29
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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11-30
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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11-31
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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11-32
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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11-33
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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11-34
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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11-35
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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11-36
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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11-37
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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11-38
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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11-39
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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11-40
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.
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11-41
The Optimal Capital Structure
Figure 11.3
Cost Functions
and Value
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11-42
Table 11.9 Basic Information on JSG
Company’s Current and Alternative Capital
Structures
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11-43
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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11-44
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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11-45
Table 11.10 Calculation of Share Value
Estimates Associated with Alternative Capital
Structures for JSG Company
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11-46