LEVERAGE AND CAPITAL STRUCTURE

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 risk The firm’s decision to incur financial risk Business 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.

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.

Break-even Analysis Objective – 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 = 0 Some actual and potential applications of BEP include: Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models. Pricing policy Labor contract negotiations Evaluation of cost structure Financial decision making

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 salaries Depreciation Insurance premiums Property taxes Rent Variable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples: Direct materials Direct Labor Energy cost associated with production Packaging Freight-out Sales commissions

Break-even Analysis Semivariables 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.

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 Error Select an arbitrary output level Calculate the corresponding EBIT amount When EBIT = 0, BEP has been found.

Finding Break-even Point Contribution Margin Analysis Contribution Margin = Unit Selling Price – Unit VC BEP (units) = FC contribution margin per unit Algebraic Analysis QB = the break-even level of units sold P = the unit sales price F = the total FC for the period V = unit VC Then, QB = F P – V

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?

Finding Break-even Point Solutions: *unit variable cost (VC) = 70% x RM 30 = RM 21 QB = F P – V = RM 360 000 = 40 000 unit RM 30 – RM 21

Finding Break-even Point The BEP in sales dollars: S* = F 1 – VC S Example: Sales $ 300 000 (-) Total VC 180 000 Revenue before FC 120 000 (-) Total FC 100 000 EBIT $ 20 000

Finding Break-even Point Solutions: S* = F = $ 100 000 1 – VC 1 – $ 180 000 S $ 300 000 = $ 100 000 1 – 0.60 = $ 250 000

Degree of Operating Leverage Leverage from the base = % change in EBIT sales level (DOLs) % change in Sales DOLs = Q (P – V) Q (P – V) – F DOLs = revenue before FC = S – VC EBIT S – VC – F

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?

Degree of Operating Leverage Solutions: DOLs = Q (P – V) Q (P – V) – F = 20 000 ($ 175 – $ 115) [20 000 ($ 175 – $ 115)] – $ 650 000 = 2.1818 times

Degree of Financial Leverage DFL = % change in EPS > 1 % change in EBIT DFLEBIT = EBIT EBIT – I * I = interest expense

Degree of Financial Leverage Example: Sales $ 600,000 (-) total VC $ 200,000 Revenue before FC $ 400,000 (-) total FC $ 200,000 EBIT $ 200,000 (-) interest expenses $ 50,000 EBT $ 150,000 Taxes (34%) $ 51,000 Net Income (EAT) $ 99,000

Degree of Financial Leverage Solutions: What is the degree of financial leverage? DFLEBIT = EBIT EBIT – I = $ 200 000 $ 200 000 – $ 50 000 = 1.33 times

Combination of Operating and Financial Leverage DCL = % change in EPS % change in Sales DCLs = (DOLs) x (DFLEBIT) DCLs = Q (P – V) Q (P – V) – F – I

Planning the Firm’s Financing Mix

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.

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) – P Ss Sb * EBIT = earning before interest and taxes I = interest expenses t = firm income tax rate P = preferred dividend paid Ss = the number of common s/o under the stock plan Sb = the number of common s/o under the bond plan

Planning the Firm’s Financing Mix Projected Income Statement Alternative 1 Alternative 2 EBIT XXXXXX XXXXXX (-) Interest XXXXX XXXXX EBT XXXXXX XXXXXX (-) Taxes XXXXX XXXXX Net Income XXXXXX XXXXXX Shares XXXXXXX XXXXXXX EPS* XXX XXX *EPS = Net Income Shares Outstanding

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 public Alternative 2: Issue 10% bond Projected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.

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 + 200,000 = 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

Planning the Firm’s Financing Mix Plan Stock Plan Bond (EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P Ss Sb (EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0 1,000,000 800,000 0.72 EBIT – RM 57,600 = 0.72 EBIT – RM 201,600 576,000 EBIT – RM 46,080,000,000 = 720,000 EBIT – RM 201,600,000,000 – 144,000 EBIT = – RM 155,520,000,000 EBIT = RM 1,080,000

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 1 Alternative 2 EBIT RM 1,080,000 RM 1,080,000 (-) Interest 80,000 280,000 EBT 1,000,000 800,000 (-) Taxes (28%) 280,000 224,000 Net Income 720,000 576,000 Shares 1,000,000 800,000 EPS* 0.72 0.72 *EPS = Net Income Shares Outstanding

Planning the Firm’s Financing Mix Which plan will provide the highest EPS for the EBIT projected level? Alternative 1 Alternative 2 EBIT RM 2,000,000 RM 2,000,000 (-) Interest 80,000 280,000 EBT 1,920,000 1,720,000 (-) Taxes (28%) 537,600 481,600 Net Income 1,382,400 1,238,400 Shares 1,000,000 800,000 EPS* 1.3824 1.548 *EPS = Net Income Shares Outstanding