© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 13: Capital Structure Management

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter focuses on analytic tools to assist managers in making capital structure decisions that maximize shareholder wealth.  It also develops techniques for measuring operating and financial leverage.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Concept of Leverage  Leverage, as the concept is used in finance, refers to the ability to cause a large change in B, given a small change in A  In this Chapter, we discuss three types of leverage Type of leverageSmall change inCauses a big change in OperatingSalesEBIT FinancialEBITEPS CombinedSalesEPS

© 2004 by Nelson, a division of Thomson Canada Limited 4 Operating Leverage  The change in Earning Before Interest and Taxes (EBIT), given a change in sales revenue.  The Degree of Operating Leverage (DOL) is the percentage change in EBIT, given a 1% change in sales revenue

© 2004 by Nelson, a division of Thomson Canada Limited 5 Financial Leverage  The change in Earnings Per Share (EPS), given a change in EBIT  The Degree of Financial Leverage (DFL) is the % change in EPS, given a 1% change in EBIT

© 2004 by Nelson, a division of Thomson Canada Limited 6 Operating and Financial Leverage  Operating and financial leverage arise due to the existence of fixed costs Fixed costs: costs that remain the same, independent of volume Variable costs: costs that rise/fall with volume  Companies can switch the ratio between fixed and variable costs to maximize profits  Companies increase their leverage to enhance shareholder returns, but in doing so, they also increase risk

© 2004 by Nelson, a division of Thomson Canada Limited 7 Example: Fixed Versus Variable Cost  A company installs underground lawn sprinklers. The company must choose between laying pipe manually or buying a machine to lay the pipe. If pipe laid manually and sales volume decreases, the company can lay off workers to reduce its costs. If pipe laid by machine, company has a fixed cost of ownership that occurs whether the machine operates or not. If sales volume increases, the fixed cost of machine ownership remains the same, whereas the variable cost of labour will rise.

© 2004 by Nelson, a division of Thomson Canada Limited 8 Cost versus Output Output Cost Fixed Costs Variable Costs Semi-variable Costs

© 2004 by Nelson, a division of Thomson Canada Limited 9 Leverage Model % Change in Sales % Change in EBIT % Change in EPS

© 2004 by Nelson, a division of Thomson Canada Limited 10 Degree of Operating Leverage  Measured as the percentage change in earnings before interest and taxes (EBIT) resulting from a one percent change in sales

© 2004 by Nelson, a division of Thomson Canada Limited 11 Operating Leverage  Must measure the Degree of Operating Leverage (DOL) at a given level of sales, X  The DOL rises as EBIT approaches 0  The DOL rises as variable costs are replaced with fixed costs  When a variable cost is replaced with a fixed cost, the breakeven level of sales will increase  When a variable cost is replaced with a fixed cost, both profits and losses grow faster as sales rise and fall on either side of the breakeven point

© 2004 by Nelson, a division of Thomson Canada Limited 12 Concept of DOL Revenue Total Cost Fixed Cost Quantity Dollars Breakeven Quantity Low Fixed Costs with High Variable Costs Low Breakeven; Profits/Losses Increase Slowly Variable Cost Profit

© 2004 by Nelson, a division of Thomson Canada Limited 13 Concept of DOL Revenue Total Cost Fixed Cost Quantity Dollars Breakeven Quantity High Fixed Costs with Low Variable Costs High Breakeven; Profits/Losses Increase Quickly Variable Cost Profit

© 2004 by Nelson, a division of Thomson Canada Limited 14 Degree of Financial Leverage  Measured as the percentage change in earnings per share (EPS) resulting from a one percent change in EBIT

© 2004 by Nelson, a division of Thomson Canada Limited 15 Degree of Financial Leverage  Must measure the Degree of Financial Leverage (DFL) at a given level of EBIT, X  DFL rises as EPS approaches 0  Divide Preferred Share dividends by one minus the tax rate to make them equivalent to interest  DFL rises as more debt is used to replace equity on the Balance Sheet  When $1 of equity is replaced with $1 of debt on the Balance Sheet, the breakeven level of EBIT will rise but EPS share will rise faster, once breakeven has been achieved

© 2004 by Nelson, a division of Thomson Canada Limited 16 Degree of Combined Leverage  Measured as the percentage change in EPS resulting from a one percent change in sales

© 2004 by Nelson, a division of Thomson Canada Limited 17 Degree of Combined Leverage Model % Change in Sales % Change in EBIT % Change in EPS DOL DFL

© 2004 by Nelson, a division of Thomson Canada Limited 18 DOL & DFL Trade Off  A firm can “trade off” operating and financial leverage to control the degree of combined leverage  A firm with a high degree of operating leverage may choose a capital structure with a low degree of financial leverage to avoid a high degree of combined leverage

© 2004 by Nelson, a division of Thomson Canada Limited 19 Finding the Probability of EPS  Breakeven EBIT is the amount of EBIT needed to just cover interest charges and preferred share dividends  The Z value tells us the number of standard deviations Breakeven EBIT is from the mean. This can be translated into the probability of achieving an EBIT of less than this amount. Breakeven EBIT – Expected EBIT Standard deviation of EBIT Z =

© 2004 by Nelson, a division of Thomson Canada Limited 20 EBIT-EPS Analysis  Determine the level of EBIT where EPS would be identical under either debt or equity financing: I d = Interest if debt alternative chosen I e = Interest if equity alternative chosen N d = Shares outstanding if debt alternative chosen N e = Shares outstanding if equity alternative chosen T = Firm’s marginal tax rate

© 2004 by Nelson, a division of Thomson Canada Limited 21 Graphical Analysis of EBIT - EPS EPS EBIT Debt Financing Equity Financing Indifference Point Advantage to equity financing Advantage to debt financing

© 2004 by Nelson, a division of Thomson Canada Limited 22 Riskiness of the Capital Structure  Compute the expected level of EBIT after expansion  Estimate the variability of operating income  Compute the indifference point between two financing plans  Estimate the probability that EBIT will exceed the indifference point

© 2004 by Nelson, a division of Thomson Canada Limited 23 Riskiness of the Capital Structure  Examine the market evidence to see if the capital structure is too risky in relation to the firm’s level of: Business risk Industry norms for leverage and coverage ratios Recommendation of the firm’s investment bankers

© 2004 by Nelson, a division of Thomson Canada Limited 24 Factors in Capital Structure Decisions  Tendency to cluster around industry average  Need for funds  Benchmark leverage ratios By lenders and bond rating agencies  Managerial risk aversion  Retain control

© 2004 by Nelson, a division of Thomson Canada Limited 25 Major Points  Leverage is the ability to create a large change in B, given a small change in A. The three types of leverage discussed are: Operating leverage Financial leverage Combined leverage (Operating & Financial)  Operating leverage arises due to the existence of fixed costs  Financial leverage arises due to the existence of debt on the Balance Sheet  High leverage is desirable, in that it magnifies returns but at a cost of additional risk