Download Some Indicators of a Firm`s Risk and Debt Capacity

Roger Clarke
Grant McQueen
Revised 2001
Some Indicators of a Firm's Risk
and Debt Capacity
Introduction
One notion of the riskiness of a firm is the extent to which the firm’s earnings can fluctuate from
period to period in response to changes in total firm revenues. The variability of earnings relative to revenues
is determined by two categories of risk. The first source of risk is business risk and is related to the basic
industry and operating decisions of the firm. Business risk depends on a number of factors including the
variability of demand for the firm’s products, the stability of sales prices and basic product input prices, and the
extent to which the firm’s costs are fixed. Each of these factors is determined to some extent by the character
of the firm's industry, but each of them is also controllable to some degree through the firm's strategic operating
decisions.
The second source of risk is financial risk. This risk is related to the firm’s financial policies,
specifically the use of debt in financing operations. The use of debt obligates a firm to make interest and
principal payments, regardless of profit levels. These fixed financial expenses compound fluctuations in
operating income (EBIT) and introduce additional risk to stockholders. Separating business and financial risk
convenient illustrates the division between firm operating and financial policies. Both are important and poor
management in one area can easily undo good management in the other.
Operating Leverage
Business risk depends in part on the extent to which a firm builds fixed costs into its operations. If
fixed costs are high, even a small change in sales can result in a large change in EBIT. The measure of a firm's
operating risk is called operating leverage. If a high percentage of a firm's operating costs is fixed, the firm
will have a high degree of operating leverage. As a result, a small change in sales will result in a large change
1
in EBIT. Operating leverage is defined as the ratio of the percentage change in operating earnings (EBIT) to
the percentage change in sales. If Δ represents the change in a variable, S represents total sales, VC represents
total variable costs, and FC represents total fixed costs, the degree of operating leverage (DOL) at a particular
level of sales is given by:
DOL =
%  EBIT
%  Sales
=
 EBIT / EBIT
 S / S
=
( S -  VC) / EBIT
 S / S
=
 S (1 - v) / EBIT
 S / S
=
S (1 - v)
EBIT
(1)
=
S - VC
EBIT
(1')
where v = VC/S is the fraction variable costs are of sales. This equation is easily derived since EBIT =
S-VC-FC. Conceptually operating leverage is best understood and interpreted using equation (1). However,
when calculating DOL, equation (1') is easier to use since it requires only one year of data and requires only
one calculation—dividing contribution by EBIT. (The specific form of Equation (1') does assume that unit
prices and variable costs are constant as sales change, however.)
As an example of operating leverage, at a sales level of $20 million, variable costs equaling 60 percent
of sales, and $4 million of fixed costs, a firm's degree of operating leverage would be:
DOL =
$20 - $12
= 2.0
$20 - $12 - $4
Consequently, the ratio of the percentage change in EBIT to a percentage change in sales would be 2.0. With
2
this degree of operating leverage a 100 percent increase in sales from $20 million to $40 million would result
in a 100(2.0) = 200 percent increase in EBIT from $4 million to $12 million. The greater the degree of
operating leverage for a firm, the greater will be the change in operating earnings as sales change. Not only
will operating earnings increase substantially as sales increase for high levels of operating leverage, but they
will likewise decrease substantially as sales decrease. For example, with DOL = 2, a 10 percent decline in
sales results in a 20 percent drop in EBIT.
Operating Breakeven Point
A concept associated with a firm's operating leverage is operating breakeven point. When a firm has
fixed costs of operation, a certain amount of revenue must be generated to cover these fixed expenses before
any operating profits are available. The point at which the firm just earns enough to cover its non-financial
fixed expenses is called the operating breakeven point. The concept is illustrated in Figure 1. For a firm with
fixed operating costs (FOC) of $4 million and variable costs amounting to 60 percent of the $5.00 sales price P
(v = 0.6 and P = $5), the firm must sell 2 million units (Q* = 2 mill.) or have sales revenue of $10 million
before it covers its fixed expenses and just breaks even. The firm's breakeven point in units can be calculated
since at the breakeven point EBIT* = 0.
EBIT
*
= S - VC - FC
= PQ* - PvQ* - FC
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Setting EBIT* to its break-even level of 0 and solving for Q* gives the breakeven number of units as:
*
=
FC
P (1 - v)
*
=
$4 million
$5 (1 - .6)
Q
Q
=
FixedCosts
Contributi on Per Unit
= 2 million
(2)
units
The breakeven level in units can be converted to dollar sales volume by multiplying through by the sales price
per unit: S* = PQ*. Notice that for the same contribution margin (l-v), the higher are the fixed costs, the
greater is the breakeven point. Since the level of fixed costs also influences the operating leverage of the firm,
the higher the firm's breakeven point, the greater will be the firm's operating leverage for any given level of
output.
Financial Leverage
Operating leverage affects changes in EBIT while financial leverage affects changes in the earnings
available to common stockholders. Financial leverage takes over where operating leverage leaves off, further
magnifying the effect of a change in sales on operating earnings because of the fixed financial costs associated
with the use of debt and preferred stock.
The degree of financial leverage (DFL) is defined as the ratio of the percentage change in EPS (or
profit after taxes) to the percentage change in EBIT. If Int represents the firm's fixed interest expense, tx is the
corporate tax rate, and assuming no preferred stock is outstanding, the degree of financial leverage is given by:
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DFL =
=
%  EPS
%  EBIT
(3)
 EPS / EPS
 EBIT / EBIT
This relationship can be simplified since:
EPS =
(EBIT - Int) (1 - tx)
# Common Shares
Therefore, for a firm with no preferred dividend payments, the degree of financial leverage is given as:
DFL =
=
 EPS / EPS
 EBIT / EBIT
 EBIT / (EBIT - Int)
 EBIT / EBIT
=
EBIT
EBIT - Int
(3')
Like DOL, DFL is better interpreted using equation (3) but easier calculated using equation (3'). The
following example illustrates both the calculation and interpretation.
For a firm with $4 million of EBIT and interest charges of $1.2 million, the degree of financial
leverage would be:
DFL =
$4.0
= 1.43
$4.0 - $1.2
Consequently, the ratio of the percentage change in EPS to the percentage change of EBIT would be 1.43. A
100 percent increase in EBIT would result in a 100(1.43) = 143 percent increase in EPS. Note also that if no
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debt or preferred stock is used, the degree of financial leverage is 1.0 so that a 100 percent increase in EBIT
would result in a 100 percent increase in EPS--financial leverage has no effect. The greater the financial
leverage for a firm, the greater will be the increase in EPS as operating earnings increase. Likewise, the greater
the financial leverage the greater will be the decrease in EPS as operating earnings decrease.
Combined Leverage
The combined effect of both operating and financial leverage influences the total risk of the firm. Two
firms with the same combined leverage may have different degrees of operating and financial leverage. A firm
with high operating leverage may offset this by using only moderate financial leverage while a firm with
moderate operating leverage can use much more financial leverage. The combined leverage is the product of
the two and is defined as the ratio of the percentage change in EPS to the percentage change in sales. The
degree of combined leverage (DCL) for a firm with no preferred stock is given by:
DCL =
=
DCL =
=
%  EPS
%  Sales
=
( EBIT / EBIT)
( S / S)
S (1 - v)
EBIT

S (1 - v)
EBIT - Int
 EPS / EPS
 S/S

( EPS / EPS
( EBIT / EBIT)
= DOL  DFL
EBIT
EBIT - Int
=
S - VC
EBIT - Int
For the firm in the previous examples, the degree of combined leverage is:
DCL = (2.0) (1.43) = 2.86, or equivalent ly,
DCL =
(4)
$20.0 - $12.0
= 2.86 .
$4.0 - $1.2
6
(4')
Consequently, the ratio of the percentage change in EPS to the percentage change in sales is 2.86. A 100
percent increase in sales would result in a 100(2.86) = 286 percent increase in EPS. The greater the firm's
combined leverage, the greater the increase or decrease in EPS as sales increase or decrease.
The usefulness of the degree of leverage concept lies in the fact that 1) it enables a manager to tell
what a change in sales will do to the firm EPS and 2) it illustrates the relationship between operating and
financial leverage and their role in affecting the total risk of the firm's earnings. The consideration of these
concepts suggests the tradeoffs a manager must make between the business risk built into the operating
decisions of the firm and the degree of financial risk involved in financing those operations. A firm with
sizeable business risk because of variable sales and high operating leverage will need to use relatively less
financial leverage (more equity financing) if the overall risk of the firm is to remain at moderate levels.
Likewise, a firm with small business risk could use relatively more financial leverage in its financing plans and
still leave the firm with moderate overall risk.
The Effects of Financial Leverage on EPS: Financial Indifference Point
Financial leverage occurs because of the fixed charges associated with sources of capital just as
operating leverage results from fixed operating costs. The firm's choice among capital sources will influence
firm EPS. In general, the firm’s EPS can be calculated by rewriting the standard vertical income statement in
the following horizontal form:
EPS =
(EBIT - Int) (1 - tx)
n
where the firm has no preferred stock and where:
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(5)
EBIT
=
earnings before interest and taxes
Int
=
interest expense
tx
=
income tax rate
n
=
number of shares of common stock
The firm usually has several different alternative sources of funds. The firm might raise sufficient
funds for an investment through debt or additional common stock. Since interest expenses are generally a
fixed dollar amount once the financing is completed, equation (5) allows us to graph the relationship between
EPS and EBIT. Figure 2 shows the EPS resulting from various levels of EBIT given two different financial
plans for raising funds. One shows the impact of incremental debt financing and the second shows the impact
of incremental equity financing. Notice that the two lines have different slopes. Conceptually, the difference
in slopes is due to differing degrees of financial leverage between alternatives. The more highly levered debt
alternative will always have the steeper slope. Mathematically, the difference in slopes is caused by differing
number of shares: under the equity alternative, operating gains and losses are spread over a greater number of
shares.
The point at which the debt and equity lines cross gives the level of EBIT for which both alternatives
result in the same EPS. This point can be calculated by equating EPS in equation (5) for two different
alternatives and then solving for the indifference level of EBIT. Because at the indifference level EPSe = EPSd,
we have:
(EBIT - Int e) (1 - tx)
ne
=
(EBIT - Int d) (1 - tx)
nd
.
where subscript e represents the incremental equity financing option and subscript d represents the incremental
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debt financing option. Cross multiplying in these expressions allows us to solve for the level of EBIT at which
the two EPS will be equal giving:
EBIT
*
=
(n e Int d - n d Int e)
.
(n e - n d )
(6)
In many cases managers relate better to levels of sales rather than to levels of EBIT. The indifference
level of EBIT can be converted to an indifference level of sales using the firm's fixed costs FC and percentage
contribution margin (l-v) by the equation:
*
S
=
FC + EBIT *
(1 - v)
(7)
since S = VC + FC + EBIT and VC = vS.
Uncommitted EPS
The calculations that permitted us to solve for the EBIT-EPS indifference point made no explicit
allowance for the repayment of the bond principal. Many bond contracts require that sinking-fund payments be
made to a trustee. Thus, some of a company's earnings are committed, and consequently not available to
stockholders. Many times the sinking-fund payment is a mandatory fixed amount and is required by a clause in
the bond indenture. Sinking-fund payments can represent a sizable cash drain on the firm's liquid resources.
Moreover, sinking-fund payments are a return of borrowed principal, so they are not tax deductible to the firm.
Because of the cash drain caused by sinking-fund requirements, the financial manager might be
concerned with the uncommitted earnings per share related to each financing plan. The calculation of
uncommitted earnings per share recognizes that sinking-fund commitments have been honored and the
remaining part can be used for discretionary purposes--such as the payment of cash dividends.
If the sinking fund payment is denoted by SF, and if no preferred stock is used, the EBIT indifference
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point for uncommitted EPS (EPSu) can be calculated as:
EPS u =
(EBIT - Int) (1 - tx) - SF
n
The uncommitted indifference point (EBIT*u) is found by the same method as before except that the EPS after
the sinking fund commitments are paid are equated to each other.
*
EBIT u =
(n e Int d - n d Int e ) + (n e SFd - n d SFe) / (1 - tx)
(n e - n d )
.
(8)
Notice that the sinking fund payments are treated differently than interest payments in the equation.
This happens because payments to a sinking fund are not tax deductible to the firm and more must be earned
before taxes in order to have enough left after taxes to make the payments.
An Example
Suppose XYZ Corporation could raise an additional $100,000 by selling stock at $100/share or by
selling bonds at par with a 10 percent coupon rate. With 1,000 shares of stock already outstanding the stock
financing would double the number of shares to 2,000. The firm currently has no debt so its total interest
expense under the debt alternative would be $10,000 per year. Using equation (6) gives the EBIT-EPS
indifference point as:
EBIT
*
=
$10,000 (2,000)
1,000
= $20,000
resulting in EPS of $5.00. If the firm has $10,000 of fixed costs and its percentage contribution margin is 10
percent, the indifference level of sales is:
10
*
S
=
10,000 + 20,000
.10
= $300,000.
Besides the indifference point, at least one other point is needed to find the EPS - EBIT line for each
financing alternative. The easiest point to find is the x-intercept. This point is found by setting EPS under
each option equal to zero and solving for EBIT:
Equity
Debt
0 = EPSe
0 =
0 = EPSd
(EBIT - 0)(1 - .5)
2,000
0 =
EBIT = 0
(EBIT - 10,000)(1 - .5)
1,000
EBIT = 10,000
Having found a second point for each financing alternative, a line can be drawn showing all
combinations of EBIT and EPS for each financing alternative. Figure 3 illustrates that as long as sales are
greater than $300,000 (or EBIT greater than $20,000), the debt alternative would give the firm higher EPS.
Suppose that the debt alternative requires an annual sinking fund payment of $5,000. The EBIT
indifference point for uncommitted EPS with a 50 percent tax rate is
*
EBIT u =
$10,000 (2,000) + [2,000 (5,000)] / (1 - .5)
1,000
= $40,000.
This is equivalent to sales of $500,000 and EPS of $10.00.
Again, a second point on the x-axis can be found by setting EPSu equal to zero and solving for EBIT
which results in 20,000. Thus, if the company chose the debt financing alternative the first $10,000 in EBIT
would cover the interest and the second $10,000 in EBIT would cover the sinking fund and taxes. Only for an
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EBIT greater than $20,000 would earnings be great enough to fund dividend payments to the common
stockholder. The dashed line shows the level of uncommitted earnings per share under the debt financing
alternative.
Although the debt alternative would give the firm the highest EPS as long as sales are greater than
$300,000 (or EBIT greater than $20,000), sales would have to be at least $500,000 (or EBIT of at least
$40,000) before the debt alternative would result in higher uncommitted EPS than the common stock
alternative.
Capital Structure Decisions—FRICTO Analysis
Having discussed the effect financial leverage has on a firm, the costs and benefits of different sources
of funds can be evaluated. Although a firm can raise money through an increasing variety of tools, basically
the firm faces two choices: debt or equity. Funds raised through debt must eventually be repaid, typically with
interest. Funds raised through equity do not have a maturity date, but represent ownership with the
accompanying risk. The firm's mix of debt and equity is known as its capital structure.
A convenient framework for analyzing the many different factors that affect the capital structure
decision is provided by the acronym FRICTO. The initials represent major factors that the manager should
consider.
F = Flexibility
R = Risk
I = Income
C = Control
T = Timing
O = Other
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These factors are not listed in order of priority or importance. (It is just that FRIC'.TO sounds better
than ICT'.FOR). For each firm, and in different economic environments, the relative importance of the various
factors will differ. However, the manager should ensure that all the important factors have been analyzed.
The first factor, flexibility, refers to the future financing options for management. As capital is raised,
the choice among alternatives for raising capital in the future may be narrowed. For example, raising capital
today through debt may impose fixed obligations and restrictive covenants that eliminate the possibility of
issuing additional debt tomorrow. Thus, for a firm that has future capital needs the relevant decision may not
be "equity vs. debt" but "debt now and equity later vs. equity now and a choice later."
Besides capital for growth, companies also want to have a financing reserve or backup liquidity to be
able to raise capital quickly to fund unforeseen needs like lawsuits, strikes, unsuccessful marketing programs,
casualty losses, etc. Here again, raising funds through equity now often allows the financial manager to meet
unforeseen situations with reserve borrowing capacity later.
Risk and income are so interrelated they cannot be discussed separately. For the investor, equity is
inherently more risky than debt since debt holders receive a fixed payment and are "in line" before equity
holders in the case of liquidation. Because of the higher risk associated with holding equity, stockholders
demand a higher return than debt holders. Consequently, from the firm's perspective, the cost of equity is
always higher than the cost of debt.
In addition to its comparative low cost, debt has the advantage that interest expense is tax deductible
and dividends are not. In effect, the government is subsidizing debt by requiring less taxes from firms who pay
interest than those who do not pay interest. Thus, management should take advantage of the low-cost debt to
boost the owner's return by applying debt to projects earning more than the cost of borrowing the necessary
funds.
The income benefits of debt can be seen in Figure 3 where the EPS (income) with incremental debt
financing is higher than the EPS with incremental equity financing at all levels of EBIT above the indifference
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point. Similarly, the earlier examples on financial leverage illustrated that using debt can yield large
improvements in income (EPS) with relatively small increases in EBIT. However, Figure 3 also illustrates the
risk disadvantages of debt.
Financial leverage, however, also magnifies declines in EBIT and therefore increases the general
riskiness of the firm. When considering the effects of risk on capital structure decisions, business risk, as well
as financial risk must be looked at. Financial risk is typically measured by using the following common ratios.
Debt Ratio
=
Total Liabilities
Total Assets
Times Interest
Earned (XIE)
=
Fixed Charge
Coverage
=
EBIT + TDFC
Interest + TDFC
Debt Service
Coverage
=
EBIT + DEP + TDFC + NTDFC
Interest + TDFC + NTDFC/(1-tx)
TDFC
=
NTDFC =
Tax deductible fixed charges other than interest (lease payments, etc.)
Non-tax deductible fixed charges (principal repayment, etc.)
EBIT
Interest Expense
where:
The use of debt consequently has both a positive and a negative effect on the value of a firm. Debt
enhances value by increasing income (as long as EBIT is above the indifference point) but debt also diminishes
value by increasing risk. The relative size of the income-risk effects of debt must be evaluated before making
the capital structure decision. Appendix B explains an additional tool to measure the trade-offs between risk
and income.
Control of a firm is ultimately decided by stockholders. If management has a majority of the
outstanding shares, they must consider the effects that additional debt or equity financing will have on the
control of the firm. If concerned about control, management may choose debt to avoid the dilution of control
14
resulting from new equity. If, however, management is not concerned about control, then the control
considerations are irrelevant to the capital structure decision.
Timing has become an increasingly important consideration for managers in the past decade as the
stock and bond markets have undergone extreme fluctuations. A firm may shy away from issuing long-term
debt in periods of high interest rates like in 1981 when the yield on AAA bonds jumped to an average of
14.2% for the year. Perhaps, with expectations of declining rates, a manager may feel the timing is such that
short-term debt is better than long-term debt. Similarly, negative conditions and trends in the overall stock
market and in a firm's stock price can affect the desirability of issuing stock. The significant issue is to
consider the current state of the capital markets and what opportunities might reasonably be expected in the
future.
Other issues besides flexibility, risk, income, control, and timing must be considered before making
the capital structure decision. Each situation is different but some common "other" considerations are:
1.
Asset structure—Are assets tangible, suitable for use as collateral?
2.
Floatation costs—How much a investment bank will charge to float the issue?
3.
Speed—How soon will the funds be needed?
4.
Management attitudes—Is management conservative?
5.
Exposure—Will additional stock increase the stock's value because of greater exposure or
liquidity?
6.
Market valuation—Is the stock valued fairly?
The FRICTO approach to financing decisions does not give answers. It does, however, give a helpful,
systematic approach to analyzing capital structure decisions. The tools presented in this paper do not tell a
manager that a debt ratio of 43% is the optimal capital structure. However, a good financial manager with an
understanding of breakeven points, degrees of operating and financial leverage, indifference points, and
FRICTO analysis can set an appropriate range for the capital structure; for example, a debt ratio of 40 to 45%.
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APPENDIX A
Financial Leverage with Preferred Stock
The body of this paper, when discussing financial leverage, assumed that preferred stock was not
included in the capital structure of the firm and that no preferred dividends (PD) were paid. For firms using
preferred stock the EPS of the firm would be:
EPS =
(EBIT - Int) (1 - tx) - PD
# Common Shares
Notice first that the use of preferred stock in financing acts similar to the use of debt in affecting the
risk of earnings available for common stockholders. The higher the preferred dividend payments, the greater
the degree of financial leverage will be. Notice second that in the uncommitted EPS calculation preferred
dividends are treated like sinking funds which are also not tax deductible to the firm.
With the addition of preferred dividend payments the formula for DFL (3') takes on an additional term
to become:
DFL =
EBIT
(EBIT - Int) - PD / (1 - tx)
The degree of combined leverage (4') changes similarly to become:
DCL =
(S - VC)
(EBIT - Int) - PD / (1 - tx)
=
S (1 - v)
(EBIT - Int) - PD / (1 - tx)
Since preferred dividends are deducted before calculating EPS, the indifference level of EBIT (formula
(6)) where EPS are equal under two financing plans, and the uncommitted EPS indifference point (formula (8))
are also altered.
16
EBIT
*
=
*
EBIT u =
(n e Int d - n d Int e) + (n e PDd - n d PDe) / (1 - tx)
ne - nd
(n e Int d - n d Int e) + [n e (PDd + SFd) - n d (PDe + SFe)] / (1 - tx)
ne - nd
The net effect of the additional terms in the two formulas will generally be to increase the indifference
point between the debt and equity alternatives.
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APPENDIX B
The Impact on Stock Price
If EBIT is greater than the EBIT - EPS indifference point, the more highly leveraged financial plan
promises to deliver a larger EPS. Strict application of the criterion of selecting the financial plan promising the
highest EPS might have the firm issuing debt most of the time. The primary weakness of the EBIT - EPS
analysis is that it ignores the effects of risk on the firm's stock price and cost of equity.
An approach similar to the EBIT - EPS indifference analysis uses the change in the firm's
price-earnings ratio (m) to capture the effect on the firm's future stock price. Since the future stock price for
the firm is equal to the product of future EPS and the firm's price-earnings ratio, equating the firm's stock price
under two different financial plans and solving for the indifference EBIT using the same technique as before
gives
*
EBIT s =
[n e Int d md - n d Int e me] + [n e md PDd - n d me Pde] / (1 - tx)
[ n e md - n d me ]
(9)
If no preferred dividends are being paid, the indifference EBIT reduces to
*
EBIT s =
n e Int d md - n d Int e me
n e md - n d me
18
(9')
Only if EBIT is greater than this indifference point would the more highly leveraged financial plan
result in a greater future stock price for the firm. Otherwise, the potentially higher EPS using more leverage
would not be sufficient to offset the increased risk investors perceive as reflected in a decline in the firm's P/E
ratio. The result would be a decrease in the firm's stock price even though EPS might increase.
An Example
The example of XYZ Corporation used previously can be expanded to show the effects of financial
leverage on the stock price of the firm. Suppose the debt financing plan increases the risk of the firm enough
to reduce the firm's price-earnings ratio from 16 to 10. Using formula (9') the resulting EBIT indifference level
for the stock price is:
*
EBIT s =
2,000 ($10,000) (10)
= $50,000
2,000 (10) - 1,000 (16)
This is equivalent to $600,000 in sales and a stock price of $200. At this indifference level, using debt
the EPS would be equal to $20.00, while with equity, the EPS would be $12.50.
Consequently, as illustrated in Figure 3, the debt alternative would give the firm the highest EPS as
long as EBIT is greater than $20,000. However, EBIT would have to be at least $40,000 before the debt
alternative would result in higher uncommitted EPS than the common stock alternative. Finally, since the debt
alternative increases the risk of the firm enough to result in a decline in the firm's price-earnings ratio, EBIT
must be at least $50,000 before the future stock price of the firm is greater under the debt plan than under the
equity plan. This is illustrated in Figure 4.
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Summary of Key Relationships
Degree of Operating Leverage
S - VC
EBIT
(1')
EBIT
EBIT - Int
(3')
DOL =
Degree of Financial Leverage
(no preferred stock)
DFL =
DCL = DOL  DFL
Degree of Combined Leverage
(no preferred stock)
=
Operating Breakeven
*
Q =
EPS Indifference
(no preferred stock)
Uncommitted EPS Indifference
(no preferred stock)
EBIT
*
EBIT u =
*
=
S - VC
EBIT - Int
FO C
P (1 - v)
n e Int d - n d Int e
(n e - n d )
(4')
(2)
(6)
(n e Int d - n d Int e) + (n e SFd - n d SFe) / (1 - tx)
(n e - n d )
(8)
Stock Price Indifference
(no preferred stock)
*
EBIT s =
20
n e Int d md - n d Int e me
n e md - n d me
(9')
Figure 1 - Operating Breakeven Point
Dollars
Total Revenue
+ EBIT
Total Costs
- EBIT
Fixed Costs
Q
21
Quantity
Figure 2 - EBIT-EPS Indifference Points
EPS
Incremental Debt Financing
Incremental Equity Financing
EBIT*
22
EBIT
Figure 3 - EPS Indifference Points
EPS $25
$20
EPS (Debt)
$15
Uncommitted
EPS (Debt)
$10
EPS and Uncommitted
EPS (Equity)
$5
$0
0
10
20
EBIT*
23
30
40
EBIT*
50
60
EBIT (000)
Figure 4 - Stock Price Indifference Points
Stock $500
Price
$400
$300
$200
$100
Stock Price (Equity)
Stock Price (Debt)
$0
0
10
20
30
40
50
60
EBIT (000)
24