1. Copyright © 2003 Pearson Education, Inc. Slide 12-0 Ch 12 Learning Goals 1.Operating, financial, and total leverage (causes & measures). 2.Optimal capital structure. 3.The EBIT-EPS approach to capital structure.

2. Copyright © 2003 Pearson Education, Inc. Slide 12-1 Leverage A given percentage change in sales revenue often causes a bigger percentage change in earnings. –Cause: ______________ costs –Name: “_________________”

3. Copyright © 2003 Pearson Education, Inc. Slide 12-2 Leverage Kinds of leverage (& their causes): –Operating leverage (fixed________________ costs) –Financial leverage (fixed________________ costs) –Total leverage (the product of the other two)

4. Copyright © 2003 Pearson Education, Inc. Slide 12-3 Leverage Generally, higher leverage means: –Increased ________________. –Increased potential return.

5. Copyright © 2003 Pearson Education, Inc. Slide 12-4 Operating Leverage

6. Copyright © 2003 Pearson Education, Inc. Slide 12-5 Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of ________________ to changes in sales. DOL can be calculated by: –Interval estimate –point estimate Operating Leverage

7. Copyright © 2003 Pearson Education, Inc. Slide 12-6 Interval Estimate of DOL DOL = % Change in EBIT % Change in Sales Operating Leverage Degree of Operating Leverage

8. Copyright © 2003 Pearson Education, Inc. Slide 12-7 Point Estimate of DOL DOL = Sales Rev - TVC Sales Rev - TVC - FC Operating Leverage Degree of Operating Leverage

9. Copyright © 2003 Pearson Education, Inc. Slide 12-8 Financial Leverage

10. Copyright © 2003 Pearson Education, Inc. Slide 12-9 Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of ______________ (or net profit after tax) to changes in EBIT. Like the DOL, DFL can be calculated by: –interval estimate –point estimate Financial Leverage

11. Copyright © 2003 Pearson Education, Inc. Slide 12-10 Interval Estimate of DFL DFL = % Change in EPS % Change in EBIT Financial Leverage Degree of Financial Leverage

12. Copyright © 2003 Pearson Education, Inc. Slide 12-11 Point Estimate of DFL DFL = EBIT EBIT - Interest Financial Leverage Degree of Financial Leverage

13. Copyright © 2003 Pearson Education, Inc. Slide 12-12 Total leverage can be viewed as the total impact of all fixed costs in the firm’s operating and financial structure. Total Leverage

14. Copyright © 2003 Pearson Education, Inc. Slide 12-13 DTL = DOL x DFL Total Leverage Degree of Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation:

15. Copyright © 2003 Pearson Education, Inc. Slide 12-14 Capital Structure Theory There is an optimal, or target__________________ __________________ that will minimize a firm’s cost of capital. The optimal capital structure balances the benefits of debt financing against its costs. Unfortunately, it is difficult to identify what a firm’s optimal capital structure is in practice.

16. Copyright © 2003 Pearson Education, Inc. Slide 12-15 Capital Structure Theory The major benefit of debt financing is the ____ _____________ provided by the federal government regarding interest payments. The costs of debt financing include increased probability of bankruptcy caused by debt obligations

17. Copyright © 2003 Pearson Education, Inc. Slide 12-16 Capital Structure Theory The probability that debt obligations will lead to bankruptcy depends on a company’s business risk and financial risk. Business risk is the risk to the firm of being unable to cover ____________________________________. High business risk is caused by –High fixed operating costs –Unstable revenues and operating costs Probability of Bankruptcy

18. Copyright © 2003 Pearson Education, Inc. Slide 12-17 Capital Structure Theory The firm’s capital structure is the mix of ___________ and _______________ it uses to finance fixed assets. The greater a firm’s use of debt financing, the greater its financial leverage, and the greater its financial risk. Financial risk is the probability it cannot meet its financial obligations. Probability of Bankruptcy

19. Copyright © 2003 Pearson Education, Inc. Slide 12-18 The Optimal Capital Structure So What is the Optimal Capital Structure? The market value of a company is maximized when the cost of capital is _________________________.

20. Copyright © 2003 Pearson Education, Inc. Slide 12-19 Graphically Kd Ke WACC Cost (%) TD/TA (%) 0 Target Capital Structure Ke Kd The Optimal Capital Structure

21. Copyright © 2003 Pearson Education, Inc. Slide 12-20 Graphically Firm Value ($) TD/TA (%) 0 Target Capital Structure V($) The Optimal Capital Structure

22. Copyright © 2003 Pearson Education, Inc. Slide 12-21 EPS-EBIT Approach to Capital Structure The EPS-EBIT approach to analyzing capital structure involves selecting the capital structure that maximizes EPS over the expected range of EBIT. Shortcoming of this approach: it does not explicitly consider the impact of _________________.