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Chapter 11 Leverage and Capital Structure. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-2 Learning Goals 1.Discuss leverage, capital.

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Presentation on theme: "Chapter 11 Leverage and Capital Structure. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 11-2 Learning Goals 1.Discuss leverage, capital."— Presentation transcript:

1 Chapter 11 Leverage and Capital Structure

2 Copyright © 2006 Pearson Addison-Wesley. 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.Describe the basic types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory.

3 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Learning Goals 4.Explain the optimal capital structure using a graphical view of the firm’s cost of capital functions and a zero-growth valuation model. 5.Discuss the EBIT-EPS approach to capital structure. 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.

4 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

5 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Leverage (cont.)

6 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

7 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

8 Copyright © 2006 Pearson Addison-Wesley. All rights reserved P = sales price per unit Q = sales quantity in units FC=fixed operating costs per period VC= variable operating costs per unit EBIT = (P x Q) - FC - (VC x Q) Breakeven Analysis: Algebraic Approach Using the following variables, the operating portion of a firm’s income statement may be recast as follows: Letting EBIT = 0 and solving for Q, we get:

9 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Q= FC P - VC Breakeven Analysis: Algebraic Approach (cont.)

10 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Q= $2,500= 500 posters $10 - $5 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. This implies that if Cheryl’s sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).

11 Copyright © 2006 Pearson Addison-Wesley. All rights reserved EBIT = (P x Q) - FC - (VC x Q) EBIT = ($10 x 500) - $2,500 - ($5 x 500) EBIT = $5,000 - $2,500 - $2,500 = $0 Breakeven Analysis: Algebraic Approach (cont.) We can check to verify that this is the case by substituting as follows:

12 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Breakeven Analysis: Graphical Approach

13 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Assume that Cheryl’s Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50, and (4) simultaneously implementing all three of these changes. Breakeven Analysis: Changing Costs and the Operating Breakeven Point

14 Copyright © 2006 Pearson Addison-Wesley. All rights reserved (1) Operating BE point = $3,000/($10-$5) = 600 units (2) Operating BE point = $2,500/($12.50-$5) = 333 units (3) Operating BE point = $2,500/($10-$7.50) = 1,000 units (4) Operating BE point = $3,000/($12.50-$7.50) = 600 units Breakeven Analysis: Changing Costs and the Operating Breakeven Point

15 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Breakeven Analysis: Changing Costs and the Operating Breakeven Point

16 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Operating Leverage

17 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Operating Leverage (cont.)

18 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

19 Copyright © 2006 Pearson Addison-Wesley. All rights reserved DOL = Percentage change in EBIT Percentage change in Sales Case 1: DOL = (+100% ÷ +50%) = 2.0 Case 2: DOL = (-100% ÷ -50%) = 2.0 Operating Leverage: Measuring the Degree of Operating Leverage (cont) Applying this equation to cases 1 and 2 in Table 12.4 yields:

20 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 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.

21 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 Operating Leverage: Fixed Costs and Operating Leverage

22 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Operating Leverage: Fixed Costs and Operating Leverage (cont.)

23 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

24 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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). Financial Leverage (cont.)

25 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Financial Leverage (cont.)

26 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

27 Copyright © 2006 Pearson Addison-Wesley. All rights reserved DFL = Percentage change in EPS Percentage change in EBIT Case 1: DFL = (+100% ÷ +40%) = 2.5 Case 2: DFL = (-100% ÷ -40%) = 2.5 Applying this equation to cases 1 and 2 in Table 12.6 yields: Financial Leverage: Measuring the Degree of Financial Leverage (cont)

28 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 = 2.5 A more direct formula for calculating DFL at a base level of EBIT is shown below. Financial Leverage: Measuring the Degree of Financial Leverage (cont)

29 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

30 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. Total Leverage (cont.)

31 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Total Leverage (cont.)

32 Copyright © 2006 Pearson Addison-Wesley. All rights reserved DTL = Percentage change in EPS Percentage change in Sales Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0 Total Leverage: Measuring the Degree of Total Leverage Applying this equation to the data Table 12.7 yields:

33 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 = $60,000/$10,000 = 6.0 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)] A more direct formula for calculating DTL at a base level of Sales, Q, is shown below. Total Leverage: Measuring the Degree of Total Leverage (cont.)

34 Copyright © 2006 Pearson Addison-Wesley. All rights reserved DTL = DOL x DFL The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = 1.2 X 5.0 = 6.0 Applying this to our previous example we get: Total Leverage: The Relationship of Operating, Financial and Total Leverage

35 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

36 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Types of Capital

37 Copyright © 2006 Pearson Addison-Wesley. All rights reserved External Assessment of Capital Structure

38 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure of Non-U.S. Firms In recent years, researchers have focused attention not only on the capital structures of U.S. firms, but on the capital structures of foreign firms as well. In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. In most European and Pacific Rim countries, large commercial banks are more actively involved in the financing of corporate activity than has been true in the U.S.

39 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure of Non-U.S. Firms (cont.) Furthermore, banks in these countries are permitted to make large equity investments in non-financial corporations—a practice forbidden in the U.S. However, similarities also exist between U.S. firms and their foreign counterparts. For example, the same industry patterns of capital structure tend to be found around the world. In addition, the capital structures of U.S.-based MNCs tend to be similar to those of foreign-based MNCs.

40 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

41 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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). Capital Structure Theory (cont.)

42 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

43 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

44 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

45 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and EBIT from its forecasting group as show in Table Capital Structure Theory: Probability of Bankruptcy (cont.) Business Risk

46 Copyright © 2006 Pearson Addison-Wesley. All rights reserved When developing the firm’s capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firm’s operating leverage, sales revenue variability, and cost predictability. Capital Structure Theory: Probability of Bankruptcy (cont.) Business Risk

47 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Let us assume that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity, and (3) the total amount of capital remains constant at $500,000, the mix of debt and equity associated with various debt ratios would be as shown in Table Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

48 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

49 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

50 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

51 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

52 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

53 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

54 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

55 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Capital Structure Theory: Probability of Bankruptcy (cont.) Financial Risk

56 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

57 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. Capital Structure Theory: Agency Costs Imposed by Lenders (cont.)

58 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. 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:

59 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. 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: Capital Structure Theory: Asymmetric Information (cont.)

60 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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: Capital Structure Theory: Asymmetric Information (cont.) 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.

61 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. The value of the firm can be defined algebraically as follows:

62 Copyright © 2006 Pearson Addison-Wesley. All rights reserved The Optimal Capital Structure

63 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

64 Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 For EBIT values of $100,000 and $200,000, the associated EPS values calculated are summarized in the table with Figure EPS-EBIT Approach to Capital Structure (cont.)

65 Copyright © 2006 Pearson Addison-Wesley. All rights reserved EPS-EBIT Approach to Capital Structure (cont.)

66 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Basic Shortcoming of EPS-EBIT Analysis Although EPS maximization is generally good for the firm’s shareholders, the basic shortcoming of this method is that it does not necessary maximize shareholder wealth because it fails to consider risk. If shareholders did not require risk premiums (additional return) as the firm increased its use of debt, a strategy focusing on EPS maximization would work. Unfortunately, this is not the case.

67 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Cooke Company, using as risk measures the coefficients of variation of EPS associated with each of seven alternative capital structures, estimated the associated returns as shown in Table Choosing the Optimal Capital Structure The following discussion will attempt to create a framework for making capital budgeting decisions that maximizes shareholder wealth— i.e., considers both risk and return. Perhaps the best way to demonstrate this is through the following example:

68 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Choosing the Optimal Capital Structure (cont.)

69 Copyright © 2006 Pearson Addison-Wesley. All rights reserved By substituting the level of EPS and the associated required return into Equation 12.12, we can estimate the per share value of the firm, P 0. Choosing the Optimal Capital Structure (cont.)

70 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Choosing the Optimal Capital Structure (cont.)

71 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Choosing the Optimal Capital Structure (cont.)

72 Copyright © 2006 Pearson Addison-Wesley. All rights reserved Insert Table here


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