FM/Capital Structure and Leverage Topic # 08 Capital Structure and Leverage Zulfiqar Hasan BBA, MBA (Finance), London Associate Professor Zulfiqar Hasan

Contents Capital Structure Policy: Objective of capital structure policy, optimal capital structure, Theories of Capital Structure, Financial Leverage, Analysis of operating leverage, financial leverage and Total Leverage. Business vs. financial risk ,Optimal capital structure, Operating leverage, Capital structure theory Zulfiqar Hasan

What is Capital structure? The combination of Debt and Equity used to finance a firm is called Capital Structure. Target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to finance its investments. Factors affecting the target Capital Structure Business Risk Firm’s Tax position Financial Flexibility Managerial Attitude Zulfiqar Hasan

Business risk is affected primarily by What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. Business risk is affected primarily by Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage. Probability Low risk High risk E(EBIT) EBIT Zulfiqar Hasan

Leverage are in two types: Operating Leverage and Financial Leverage. Meaning of Leverage Leverage is the degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders‘ return on investment and often there are tax advantages associated with borrowing Leverage are in two types: Operating Leverage and Financial Leverage. Zulfiqar Hasan

Operating vs Financial Leverage Zulfiqar Hasan

Fixed Costs vs Variable Costs Fixed costs: These are those costs that are not dependent on the quantity of product. In other words, these costs stay the same whether you produce one piece of shirt or many pieces of shirts in your garments. Example: Rent of a garments factory. Whether you are producing anything or not, you still have to pay the rent every month so for all intents and purposes your rent is a fixed cost. Examples of Fixed Costs: salaries, rent, advertising, insurance and office supplies Variable Costs: Variable costs are costs that are dependent on the quantity of products. Example: Raw materials – Cloths. If 5 feet cloths need to make 01 Shirt, 10 feet cloths will be needed to make 02 shirts. Examples of Variable costs: material, labor, utilities, and delivery costs, hourly wages @Zulfiqar Hasan Zulfiqar Hasan

What is operating leverage? FM/Capital Structure and Leverage What is operating leverage? Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes, or EBIT. (EBIT is a descriptive label for operating profits.) EBIT= Sales – – Fixed Operating Costs Variable Operating Costs So, EBIT=(PXQ)-FC-(VCXQ) where, P = sales price per unit Q = sales quantity FC = total fixed operating costs VC = variable operating costs per unit Zulfiqar Hasan

Breakeven analysis & Operating Breakeven Point Breakeven analysis, sometimes called cost-volume-profit analysis, is used by the firm (1) to determine the level of operations necessary to cover all operating costs and (2) to evaluate the profitability associated with various levels of sales. The firm’s operating breakeven point is the level of sales necessary to cover all operating costs. At that point, earnings before interest and taxes equals Zero (0). Operating Breakeven Point is the Sales Volume where EBIT=0) EBIT=(PXQ)-FC-(VCXQ) EBIT=0 So, (PXQ)-FC-(VCXQ) = 0 P = Price per Unit FC = Total Fixed Cost VC = Variable Cost per unit Zulfiqar Hasan

Example 01: Operating Breakeven Point Suppose a firm has $10000 in fixed operating costs, its price per unit for its product is $10 and its variable costs per unit are $8. What is the break even quantity of units to sell? What is the breakeven dollar sales? Mind it, this is the point where EBIT IS ZERO. Zulfiqar Hasan

Example 02: Breakeven analysis Barry Carter is considering opening a record store. He wants to estimate the number of CDs he must sell to break even. The CDs will be sold for $13.98 each, variable operating costs are $10.48 per CD, and annual fixed operating costs are $73,500. Find the operating breakeven point in number of CDs. Calculate the total operating costs at the breakeven volume found in part a. If Barry estimates that at a minimum he can sell 2,000 CDs per month, should he go into the record business? How much EBIT will Barry realize if he sells the minimum 2,000 CDs per month noted in part c? Zulfiqar Hasan

Solution: Example 02- Breakeven Analysis b. Total operating costs = FC + (Q x VC) Total operating costs = $73,500 + (21,000 x $10.48) Total operating costs = $293,580 c. 2,000 x 12 = 24,000 CDs per year. 2,000 records per month exceeds the operating breakeven by 3,000 records per year. Barry should go into the CD business. d. EBIT = (P x Q) - FC - (VC x Q) EBIT = ($13.98 x 24,000) - $73,500 - ($10.48 x 24,000) EBIT = $335,520 - $73,500 - $251,520 EBIT = $10,500 Zulfiqar Hasan

Practice: Break Even Quantity 10,000 120000 01. Given P=$12 per unit, VC= $9 per unit, and FC =$30,000 calculate Q, the breakeven sales quantity and Volume. 02. Assume that Cheryl’s Posters, a small poster retailer, has fixed operating costs of $2,500, its sale price per unit (poster) is $10, and its variable operating cost per unit is $5. What is Break Even Quantity 500 units 03. Addition to problem 02, 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. Results: 600 units; 333.33 units; 1,000 units; 600 units Zulfiqar Hasan

Example 02: Changes in EBIT Suppose a firm has $10000 in fixed operating costs, its price per unit for its product is $10 and its variable costs per unit are $8. Suppose your initial sales quantity is 8000 units. Find out EBIT? EBIT=(PXQ)-FC-(VCXQ) =($10X8000)-$10000-($8X8000) =$6000 Zulfiqar Hasan

Now find out the % change in EBIT Changes in EBIT… Example 03: Suppose a firm has $10000 in fixed operating costs, its price per unit for its product is $10 and its variable costs per unit are $8. Suppose your initial sales quantity is 8000 units. If Q increases by 50% to 12000 units what will be new EBIT? SOLUTIONS: EBIT = ($10 x 12,000) - $10,000 - ($8 x 12,000) = $14,000 Now find out the % change in EBIT Practice: 04: Suppose P = $12 per unit, VC = $9 per unit, and FC = $30,000. At a Q of 20,000 units, what is the percentage change in EBIT from a Q of 30,000? -50% Zulfiqar Hasan

% Changes in Sales Example 04: Suppose P = $12 per unit, VC = $9 per unit, and FC = $30,000. At a Q of 20,000 units, what is the percentage change in sales from a Q of 30,000 units? A. -66.7% B. -33.3% C. +33.3% D. +66.7% WORKED Zulfiqar Hasan

Practice: % Change in Sales Practice 05: Suppose P = $12 per unit, VC = $9 per unit, and FC = $30,000. At a Q of 40,000 units, what is the percentage change in sales from a Q of 30,000 units? A. -66.7% B. -33.3% C. +33.3% D. +66.7% Zulfiqar Hasan

Degree of Operating Leverage: Operating leverage is the ability to use fixed operating costs to magnify the effects of changes in sales on earnings before interest and taxes. Operating leverage results from the existence of fixed operating costs in the firm's income stream. The degree of operating leverage (DOL) is measured by dividing a percent change in EBIT by the percent change in sales. .The Percentage change in operating income (EBIT) associated with a given percentage change in sales. Practice 06: If percentage change in EBIT is -50% and percentage change in sales is -33%, what will be the degree of operating leverage (DOL)? Zulfiqar Hasan

Practice 07: DOL’s Problems and Solutions Suppose P = $12 per unit, VC = $9 per unit, and FC = $30,000. What is the degree of operating leverage (DOL) at a sales quantity of 30,000 units from a Q of 40000 units? 1.33 Zulfiqar Hasan

What is financial leverage? Financial risk? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. Business Risk vs. Financial Risk Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued: More debt, more financial risk. Concentrates business risk on stockholders. Zulfiqar Hasan

Calculating EPS Here, ÷ Number of shares of common stock outstanding EBIT Interest --------------------------------------------------- Earnings before tax (EBT) Income taxes -------------------------------------------------------- Net income Preferred stock dividends Earnings available for common stockholders ÷ Number of shares of common stock outstanding --------------------------------------------------------- Earnings per share (EPS) Here, PD= Preferred Dividend t = Tax Rate I = Interest (Total) Zulfiqar Hasan

Example 05: Findings EPS Suppose your firm has EBIT of $60,000, debt of $100,000 with an 8% annual coupon rate, 1,000 shares of preferred stock outstanding paying an annual dividend of $4 per share, 5,000 shares of common stock, and a 40% tax rate. What is your firm's EPS? Interest = $100,000 x .08 = $8,000 PD = 1,000 x $4 = $4,000 Zulfiqar Hasan

Example 06 : Solve It! Suppose your firm has EBIT of $30,000, debt of $100,000 with an 8% annual coupon rate, 1,000 shares of preferred stock outstanding paying an annual dividend of $4 per share, 5,000 shares of common stock, and a 40% tax rate. What is your firm's EPS? Zulfiqar Hasan

Example 07 : Percentage Change in EPS Using EBIT of $60,000 as a base (Example 05) and your ANSWER from Example 6, what is the percentage change in EPS? Example 08: % Change in EBIT Using EBIT of $60,000 as a base, what is the percentage change in EBIT if EBIT becomes $30,000? Zulfiqar Hasan

Degree of Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effects of changes in EBIT on earnings per share. Financial leverage is caused by the presence of fixed financial costs such as interest on debt and preferred stock dividends. Example 09: Calculating DFL: Using your Answers from Problems 3 and 4, what is the Degree of Financial Leverage, DFL? Zulfiqar Hasan

Degree of Total Leverage The total leverage of the firm is the combined effect of fixed costs, both operating and financial, and is therefore directly related to the firm's operating and financial leverage. Increases in these types of leverage will increase total risk and vice versa. Both types of leverage do complement each other in the sense that their effects are not additive but rather they are multiplicative. This means that the overall effect of the presence of these types of leverage on the firm is quite great, since their combined leverage more than proportionately magnifies the effects of changes in sales on earnings per share. Zulfiqar Hasan

Integrated Practice 01: DOL, DFL and DTL (DCL) Calculate DOL, DFL and DTL (DCL) from the below table. 2010 2011 Sales $8,000,000 $16,000,000 - variable operating costs 3,000,000 6,000,000 - fixed operating costs 1,000,000 EBIT $4,000,000 $9,000,000 - interest expense 2,000,000 EBT $2,000,000 $7,000,000 - taxes (@40%) 800,000 2,800,000 EAT $1,200,000 $4,200,000 - preferred stock dividends 500,000 Earnings available to common stockholders $700,000 $3,700,000 Common shares outstanding 70,000 Earnings per share (EPS) $10 $52.86 Zulfiqar Hasan

EBIT = Earnings before interest and taxes I = Interest expense Base-Level DOL & DFL EBIT = Earnings before interest and taxes I = Interest expense PD = Preferred dividends t = Corporate tax rate Zulfiqar Hasan

Practice 08: DFL At Base Level DFL At Base Level Suppose your firm has debt of $100,000 with an 8% annual coupon rate, 1,000 shares of preferred stock outstanding paying an annual dividend of $4 per share, 5,000 shares of common stock, and a 40% tax rate. What is your firm's Degree of Financial Leverage at a base level EBIT of $30,000? Zulfiqar Hasan

Optimal Capital Structure Optimal Capital Structure is that capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt’s risk-related costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital. Zulfiqar Hasan

Practice 09: Problems and Solutions of DTL Suppose your firm has debt of $100,000 with an 8% annual coupon rate, 1,000 shares of preferred stock outstanding paying an annual dividend of $4 per share, 5,000 shares of common stock, and a 40% tax rate. Given DOL is 1.52, what is your firm's Degree of Total Leverage (DTL) at a base level of sales of 30,000 units? Answer: 1.98 Zulfiqar Hasan

How would these factors affect the Target Capital Structure? Other factors to consider when establishing the firm’s target capital structure? Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks? Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate Zulfiqar Hasan

What are “signaling” effects in capital structure? Signaling theory, discussed earlier, suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress P0 because of signaling effects. What are “signaling” effects in capital structure? Assumptions: Managers have better information about a firm’s long-run value than outside investors. Managers act in the best interests of current stockholders. Therefore, managers can be expected to: issue stock if they think stock is overvalued. issue debt if they think stock is undervalued. As a result, investors view a common stock offering as a negative signal--managers think stock is overvalued. Zulfiqar Hasan

Practice at Home 01: Breakeven point and all forms of leverage TOR most recently sold 100,000 units at $7.50 each; its variable operating costs are $3.00 per unit, and its fixed operating costs are $250,000. Annual interest charges total $80,000, and the firm has 8,000 shares of $5 (annual dividend) preferred stock outstanding. It currently has 20,000 shares of common stock outstanding. Assume that the firm has a 40% tax rate. a. At what level of sales (in units) would the firm break even on operations (that is, EBIT$0)? b. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the current level of sales and (2) a 120,000-unit sales level. c. Using the current $750,000 level of sales as a base, calculate the firm’s degree of operating leverage (DOL). d. Using the EBIT associated with the $750,000 level of sales as a base, calculate the firm’s degree of financial leverage (DFL). e. Use the degree of total leverage (DTL) concept to determine the effect (in percentage terms) of a 50% increase in TOR’s sales from the $750,000 base level on its earnings per share. Zulfiqar Hasan

Practice at Home 03: Degree of operating leverage Grey Products has fixed operating costs of $380,000, variable operating costs of $16 per unit, and a selling price of $63.50 per unit. a. Calculate the operating breakeven point in units. b. Calculate the firm’s EBIT at 9,000, 10,000, and 11,000 units, respectively. c. With 10,000 units as a base, what are the percentage changes in units sold and EBIT as sales move from the base to the other sales levels used in part b? d. Use the percentages computed in part c to determine the degree of operating leverage (DOL). e. Use the formula for degree of operating leverage to determine the DOL at 10,000 units. Zulfiqar Hasan