Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 11 Leverage and Capital Structure

Ch 11 Learning Goals 1.Causes & measures of operating, financial, and total leverage. 2.Business, financial & total risk. 3.Optimal capital structure. 11-2

Leverage A change in sales revenue often causes a bigger percentage change in earnings. –Cause: fixed costs –Name: “leverage” 11-3

Leverage Kinds of leverage (& causes): –Operating leverage (fixed operating costs) –Financial leverage (fixed financing costs) –Total leverage (the product of the other two) Generally, higher leverage means: –Increased risk. –Increased potential return. 11-4

11-5 Operating Leverage Table 11.4 The EBIT for Various Sales Levels

11-6 Measuring Operating Leverage: the Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of EBIT to changes in Sales. A company’s DOL can be calculated two different ways: –point estimate –interval estimate

11-7 Financial Leverage Table 11.6 The EPS for Various EBIT Levels a

11-8 Measuring Financial Leverage: the Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of EPS to changes in EBIT. Like DOL, DFL can be calculated two different ways: –point estimate –interval estimate

11-9 Total Leverage Total leverage can be viewed as the total impact of the fixed costs in the firm’s operating and financial structure. The relationship between DOL, DFL and DTL is illustrated by the following equation: DTL = DOL X DFL

11-10 The Firm’s Capital Structure The firm’s capital structure is the mix of debt and equity it uses to finance fixed assets. The optimal capital structure for a particular firm depends on: –its business risk –the risk tolerance of its owners & managers

Determinants of Business Risk High business risk is the result of high fixed operating costs (high DOL) unstable demand for firm’s products volatile costs (raw materials, for example) 11-11

Financial Risk Financial risk is the risk that the firm cannot meet its financial obligations & is the result of debt financing. The total risk a firm faces and the probability of bankruptcy are the result of both business risk and financial risk. Firms with high business risk should use less debt financing. As a result, the optimal capital structure is not the same for all industries or firms

11-13 Optimal Capital Structure Although higher EPS is generally good for the firm’s shareholders, the optimal capital structure is not usually the one that maximizes EPS. We must also consider the impact of the capital structure on the firm’s risk.

11-14 Optimal Capital Structure (cont.) Figure 11.6 Estimating Value

Optimal Capital Structure The optimal capital structure results in: –Minimum WACC –Maximum stock price 11-15