3 Chapter Objectives Business Risk and Financial Risk Break-even analysisOperating leverage, financial leverage, and combined leverageCalculate: operating leverage, financial leverage, and combined leverageOptimal capital structureCapital structure theoryGraph the moderate position on capital structureAgency costs and free cash flowBasic tools of capital structure managementBusiness risk and global sales
4 RiskLikely variability associated with expected revenue or income streamsBusiness Risk Dispersion (variability) in the firm’s expected earnings before interest and taxesFinancial Risk Additional 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
5 LeverageFinancial Leverage Financing 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 stockholdersOperating leverage Incurrence of fixed operating costs in the firm’s income stream.Combined leverage
6 Break-even AnalysisDetermine 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 dollarsShort-run concept
7 Elements of Break-even Fixed Costs or Indirect CostsVariable Costs or Direct CostsRevenueVolume
8 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
10 Variable Costs Direct Costs Fixed per unit of output but vary in total as output changesExamples:Direct LaborDirect MaterialsPackagingSales commissions
11 Revenue and Volume Total Revenue Volume of output Total sales dollars Equal to the selling price per unit multiplied by the quantity soldVolume of outputFirm’s level of operations and may be stated either as a unity quantity or as sales dollars
12 Break-even PointNumber 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
13 Problem Selling Price per unit is $10 Variable cost per unit is $6 Fixed costs are $100,000What is breakeven?
14 Algebraic Approach PxQ – [VxQ + F] = 0 (PxQ) – (VxQ) – F = 0 Q (P-V) = FQb = F/P-VWhere:Q = units sold P = Sales priceQb = break even level of quantityF = Fixed Costs V = Variable Costs$100,000 / 10 – 6 = 25,000
15 Contribution Margin Approach Sales – variable costs = contribution marginDifference between unit selling price and unit variable costSales price – variable costs = contribution margin (CM)Fixed costs / CM = Break-even$100,000/ $4 = 25,000
16 Example Sales $ 300,000 Var costs 180,000 Revenue 120,000 Fixed Costs 100,000EBIT $ 20,000Per unit sales price is $10Per unit variable cost is $6
17 Break-even in Dollars S = Fixed costs / [1 – (Var costs/sales)] 100,000/ [1 – (180,000/300,000)]BE in dollars = $250,000BE in units is $10 = $250,000
18 Operating LeverageResponsiveness of the firm’s EBIT to fluctuation in SalesHow will a company respond to a percentage change in sales?Percentage change in EBIT / Percentage change in sales
19 Operating LeveragePercentage change in EBIT / Percentage change in salesPercentage change in EBIT =EBITt1 – EBITt / EBITtPercentage Change in sales =Salest1 – Salest / Salest
20 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 salesPercentage change in EBIT = 5% x 6 or 30%If the firm increases sales by 5%, EBIT will increase by 30%
22 Operating Leverage Operating leverage is present when: Percentage change in EBIT / Percentage change in sales > 1.00As the degree of operating leverage increases, the more profits will vary with a percentage change in sales
23 Financial LeverageFinancing a portion of the firm’s assets with securities bearing a fixed rate of returnA firm is employing financial leverage and exposing its owners to financial risk when:Percentage change in EPS / percentage change in EBIT > 1.00Measured by Percentage change in EPS / Percentage change in EBIT
24 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 EPSPercentage change in EPS/Percentage change in salesOperating Leverage X Financial Leverage = Combined Leverage
25 Combined Leverage OL X FL = CL or Combined Leverage = Q (P-V) / Q(P-V) – F – I
26 Structure Financial Structure Capital Structure Mix of all items that appear on the right-hand side of the company’s balance sheetCapital StructureMix of the long-term sources of funds used by the firmFinancial Structure – Current liabilities = Capital Structure
27 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?
28 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 priceThe funds mix that will minimize the firm’s composite cost of capital—optimal capital structure
29 Capital Structure Theory The effect of financial leverage on the overall cost of capitalCan 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
30 Firm Failure--Bankruptcy Threat of financial distress causes the cost of debt to riseAs financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield of debt financing
31 Debt CapacityMaximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital.
32 Agency CostsTo ensure that agent-managers act in shareholders best interest, firms must:1. Offer incentivesCompensation plans and perquisites2. Monitor their workBonding, auditing, structuring, reviewingThe costs of the incentives and monitoring must be borne by the stockholders
33 Capital Structure Management and Agency Costs Capital Structure management gives rise to agency costs.Agency problems stem from conflicts of interestCapital structure management encompasses a natural conflict between stockholders and bondholders.
34 Cost of Capital-Capital Structure Relationship Interest expense is tax deductibleProbability of bankruptcy directly related to the use of financial leverageBecause interest is deductible, the use of debt financing should result in higher total market value for firms outstanding securitiesTax Shield = rd(m)(t)r = ratem = principalt = marginal tax rate