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Chapter 12

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Determining the Financing Mix

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Chapter Objectives Business Risk and Financial Risk Break-even analysis Operating leverage, financial leverage, and combined leverage Calculate: operating leverage, financial leverage, and combined leverage Optimal capital structure Capital structure theory Graph the moderate position on capital structure Agency costs and free cash flow Basic tools of capital structure management Business risk and global sales

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Risk Likely variability associated with expected revenue or income streams Business RiskDispersion (variability) in the firm’s expected earnings before interest and taxes Financial RiskAdditional variability in earnings available to the firm’s common shareholders and the additional chance of insolvency borne by the common shareholder caused by the use of financial leverage

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Leverage Financial LeverageFinancing a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholders Operating leverageIncurrence of fixed operating costs in the firm’s income stream. Combined leverage

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Break-even Analysis Determine the break-even quantity of output by examining the relationships among the firm’s cost structure, volume of output, and profit. Break-even may be calculated in units or sales dollars Short-run concept

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Elements of Break-even Fixed Costs or Indirect Costs Variable Costs or Direct Costs Revenue Volume

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Fixed Costs Indirect Costs – Fixed in total amount over some relevant range of output. – As production volume changes, fixed costs per unit of product changes as fixed costs are spread over a changed quantity of output (but total remains the same.) – Vary per unit but remain fixed in total

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Fixed Costs Examples: – Administrative Salaries – Depreciation – Insurance – Property Taxes – Rent

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Variable Costs Direct Costs Fixed per unit of output but vary in total as output changes Examples: – Direct Labor – Direct Materials – Packaging – Sales commissions

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Revenue and Volume Total Revenue – Total sales dollars – Equal to the selling price per unit multiplied by the quantity sold Volume of output – Firm’s level of operations and may be stated either as a unity quantity or as sales dollars

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Break-even Point Number of units or sales dollars that must be produced and sold to arrive at EBIT = $0. [Sales price per unit X Units sold] – [(Variable cost per unit X Units sold) + (Total fixed costs)]= EBIT = 0

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Problem Selling Price per unit is $10 Variable cost per unit is $6 Fixed costs are $100,000 What is breakeven?

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Algebraic Approach PxQ – [VxQ + F] = 0 (PxQ) – (VxQ) – F = 0 Q (P-V) = F Q b = F/P-V Where: Q = units soldP = Sales price Q b = break even level of quantity F = Fixed Costs V = Variable Costs $100,000 / 10 – 6 =25,000

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Contribution Margin Approach Sales – variable costs = contribution margin Difference between unit selling price and unit variable cost Sales price – variable costs = contribution margin (CM) Fixed costs / CM = Break-even $100,000/ $4 =25,000

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Example Sales$300,000 Var costs180,000 Revenue120,000 Fixed Costs100,000 EBIT$ 20,000 Per unit sales price is $10 Per unit variable cost is $6

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Break-even in Dollars S = Fixed costs / [1 – (Var costs/sales)] 100,000/ [1 – (180,000/300,000)] BE in dollars = $250,000 BE in units is $10 = $250,000

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Operating Leverage Responsiveness of the firm’s EBIT to fluctuation in Sales How will a company respond to a percentage change in sales? Percentage change in EBIT / Percentage change in sales

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Operating Leverage Percentage change in EBIT / Percentage change in sales Percentage change in EBIT = EBIT t1 – EBIT t / EBIT t Percentage Change in sales= Sales t1 – Sales t / Sales t

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Operating Leverage Example : If a company has an operating leverage of 6, then what is the change in EBIT if sales increase by 5%? Percentage change in EBIT = Operating leverage X Percentage change in sales Percentage change in EBIT = 5% x 6 or 30% If the firm increases sales by 5%, EBIT will increase by 30%

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Alternative Operating Leverage Calculation DOL = Revenue before fixed costs / EBIT or Sales – Variable costs / (Sales – Variable costs – Fixed costs

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Operating Leverage Operating leverage is present when: Percentage change in EBIT / Percentage change in sales > 1.00 As the degree of operating leverage increases, the more profits will vary with a percentage change in sales

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Financial Leverage Financing a portion of the firm’s assets with securities bearing a fixed rate of return A firm is employing financial leverage and exposing its owners to financial risk when: Percentage change in EPS / percentage change in EBIT > 1.00 Measured by Percentage change in EPS / Percentage change in EBIT

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Combining Operating Leverage and Financial Leverage Changes in sales revenues cause greater changes in EBIT; changes in EBIT create larger variations in both EPS and total earnings available to common shareholders, if the firm chooses to use financial leverage. Combining operating and financial leverage causes rather large variations in EPS Percentage change in EPS/Percentage change in sales Operating Leverage X Financial Leverage = Combined Leverage

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Combined Leverage OL X FL = CL or Combined Leverage = Q (P-V) / Q(P-V) – F – I

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Structure Financial Structure – Mix of all items that appear on the right-hand side of the company’s balance sheet Capital Structure – Mix of the long-term sources of funds used by the firm Financial Structure – Current liabilities = Capital Structure

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Financial Structure Requires answers to : 1.How should a firm best divide its total fund sources between short- and long-term components? 2.In what proportions relative to the total should the various forms of permanent financing be utilized?

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Capital Structure Management Answers the question: In what proportions relative to the total should the various forms of permanent financing be utilized? Objective: Mix the permanent sources of funds used by the firm in a manner that will maximize the company’s common stock price The funds mix that will minimize the firm’s composite cost of capital—optimal capital structure

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Capital Structure Theory The effect of financial leverage on the overall cost of capital Can the firm affect its overall cost of funds, either favorably or unfavorable by varying the mixture of financing used? Firms strive to minimize the cost of using financial capital

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Firm Failure--Bankruptcy Threat of financial distress causes the cost of debt to rise As financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield of debt financing

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Debt Capacity Maximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital.

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Agency Costs To ensure that agent-managers act in shareholders best interest, firms must: 1.Offer incentives – Compensation plans and perquisites 2.Monitor their work – Bonding, auditing, structuring, reviewing The costs of the incentives and monitoring must be borne by the stockholders

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Capital Structure Management and Agency Costs Capital Structure management gives rise to agency costs. Agency problems stem from conflicts of interest Capital structure management encompasses a natural conflict between stockholders and bondholders.

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Cost of Capital-Capital Structure Relationship Interest expense is tax deductible Probability of bankruptcy directly related to the use of financial leverage Because interest is deductible, the use of debt financing should result in higher total market value for firms outstanding securities Tax Shield = r d (m)(t) r = rate m = principal t = marginal tax rate

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