2 Business Risk and Financial Risk Risk – the likely variability associated with expected revenue streams.The variations in the income stream can be attributed to:The firm’s exposure to business riskThe firm’s decision to incur financial riskBusiness Risk – the risk that comes from the nature of the firm’s operating activities.Financial Risk – the risk that comes from the financial policy (i.e capital structure) of the firm.
3 Financial and Operating Leverage Financial Leverage – the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.Operating Leverage – the incurrence of fixed operating costs in the firm’s income stream.
4 Break-even AnalysisObjective – to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit.The break-even quantity of output results in an EBIT level = 0Some actual and potential applications of BEP include:Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models.Pricing policyLabor contract negotiationsEvaluation of cost structureFinancial decision making
5 Break-even Analysis Essential elements of the break-even model: Fixed cost – cost that do not vary in total amount as the sales volume or the quantity of output changes. Examples:Administrative salariesDepreciationInsurance premiumsProperty taxesRentVariable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples:Direct materialsDirect LaborEnergy cost associated with productionPackagingFreight-outSales commissions
6 Break-even AnalysisSemivariables costs (Semifixed cost) – cost that exhibit the joint characteristics of both FC and VC over different ranges of output. Examples: Salaries paid to production supervisors.
7 Finding Break-even Point The break-even is just a simple adaptation of the firm’s income statement expressed as:Profit (π) = Sales – (Total VC + Total FC)3 ways to find BEP:Trial and ErrorSelect an arbitrary output levelCalculate the corresponding EBIT amountWhen EBIT = 0, BEP has been found.
8 Finding Break-even Point Contribution Margin AnalysisContribution Margin = Unit Selling Price – Unit VCBEP (units) = FCcontribution margin per unitAlgebraic AnalysisQB = the break-even level of units soldP = the unit sales priceF = the total FC for the periodV = unit VCThen,QB = FP – V
9 Finding Break-even Point Example:Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360,000, how many dress must MC sell to breakeven?
11 Finding Break-even Point The BEP in sales dollars:S* = F1 – VCSExample:Sales $(-) Total VCRevenue before FC(-) Total FCEBIT $
12 Finding Break-even Point Solutions:S* = F = $1 – VC – $S $= $1 – 0.60= $
13 Degree of Operating Leverage Leverage from the base = % change in EBITsales level (DOLs) % change in SalesDOLs = Q (P – V)Q (P – V) – FDOLs = revenue before FC = S – VCEBIT S – VC – F
14 Degree of Operating Leverage Example:Avitar Corporation manufactures a line of computer memory expansion boards used in microcomputers. The average selling price of its finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650,000 per year. Avitar estimates the sales in next year will be 20,000 units. What is Avitar expected degree of operating leverage?
16 Degree of Financial Leverage DFL = % change in EPS > 1% change in EBITDFLEBIT = EBITEBIT – I* I = interest expense
17 Degree of Financial Leverage Example:Sales $ 600,000(-) total VC $ 200,000Revenue before FC $ 400,000(-) total FC $ 200,000EBIT $ 200,000(-) interest expenses $ 50,000EBT $ 150,000Taxes (34%) $ 51,000Net Income (EAT) $ 99,000
18 Degree of Financial Leverage Solutions:What is the degree of financial leverage?DFLEBIT = EBITEBIT – I= $$ – $= 1.33 times
19 Combination of Operating and Financial Leverage DCL = % change in EPS% change in SalesDCLs = (DOLs) x (DFLEBIT)DCLs = Q (P – V)Q (P – V) – F – I
21 Planning the Firm’s Financing Mix Financial Structure – the mix of all funds source that appear on the right side of the balance sheet.Capital Structure – the mix of long term sources of funds used by the firm. Basically, this concept omits short-term liabilities.Financial Structure Design – the management activity of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds.Optimal Capital Structure – the unique capital structure that minimizes the firm’s composite cost of long term capital.
22 Planning the Firm’s Financing Mix EBIT-EPS indifference point – the level of EBIT that will equate EPS between two difference financing plans.EPS: Stock Plan EPS: Bond Plan(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – PSs Sb* EBIT = earning before interest and taxesI = interest expensest = firm income tax rateP = preferred dividend paidSs = the number of common s/o under the stock planSb = the number of common s/o under the bond plan
23 Planning the Firm’s Financing Mix Projected Income StatementAlternative 1 Alternative 2EBIT XXXXXX XXXXXX(-) Interest XXXXX XXXXXEBT XXXXXX XXXXXX(-) Taxes XXXXX XXXXXNet Income XXXXXX XXXXXXShares XXXXXXX XXXXXXXEPS* XXX XXX*EPS = Net IncomeShares Outstanding
24 Planning the Firm’s Financing Mix Example:ING Berhad is financed entirely with 800,000 shares of common stock priced at RM 5 per unit and RM 1,000,000 worth of debt (8% 10 years bond). The company plans to raise an additional RM 2,000,000 to finance new project and considering two alternatives;Alternative 1: 200,000 new common shares sold to the publicAlternative 2: Issue 10% bondProjected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.
25 Planning the Firm’s Financing Mix Solutions:Calculate the indifference level of EBIT between two alternatives.* Plan Stock (alternative 1)= Interest on bond = (1,000,000 x 8% = RM 80,000)Unit shares = 800, ,000 = 1,000,000*Plan Bond (alternative 2)= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)Unit shares = 800,000
27 Planning the Firm’s Financing Mix Prepare the projected income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in question (i)Alternative Alternative 2EBIT RM 1,080, RM 1,080,000(-) Interest , ,000EBT ,000, ,000(-) Taxes (28%) , ,000Net Income , ,000Shares ,000, ,000EPS**EPS = Net IncomeShares Outstanding
28 Planning the Firm’s Financing Mix Which plan will provide the highest EPS for the EBIT projected level?Alternative Alternative 2EBIT RM 2,000, RM 2,000,000(-) Interest , ,000EBT ,920, ,720,000(-) Taxes (28%) , ,600Net Income ,382, ,238,400Shares ,000, ,000EPS**EPS = Net IncomeShares Outstanding