14 Capital Structure Management in Practice ©2006 Thomson/South-Western

2 Introduction This chapter focuses on tools of analysis that can assist managers in making capital structure decisions that will lead to a maximization of shareholder wealth. It develops techniques, derived from accounting data, for measuring operating and financial leverage.

3 Operating and Financial Leverage From fixed operating or fixed capital costs Operating costs  Costs of sales  General & administrative costs Capital costs  Interest charges  Preferred dividends  Income taxes

4 Operating and Financial Leverage Operating Leverage  Results from fixed operating costs such that a change in sales revenue is magnified into a relatively large change in EBIT Financial Leverage  Results from fixed capital costs such that a change in EBIT is magnified into a relatively large change in EPS See leverage model

5 Behavior of Variable Costs

6 Behavior of Fixed Costs

7 Behavior of Semivariable Costs

8 Leverage Model DOL DFL % Sales % EBIT % EPS

9 DOL Measured as a percent change in EBIT resulting from a given percent change in sales Original values Sales – VC – FC = EBIT DOL at X = Sales – Variable Costs EBIT

10 DFL Measured as the percent change in EPS resulting from a given percent change in EBIT P/S dividends before taxes DFL at X = How does a banker looks at financial leverage? EBIT EBIT – I – D p /(1 – T)

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12 DCL Measured as a percent change in EPS resulting from a given percent change in sales See DCL model DCL at X = DOL  DFL DCL at X = Sales – Variable Costs EBIT – I – D p /(1 – T)

13 DCL Model DOL DFL % Δ Sales % Δ EBIT % Δ EPS DCL

14 DOL & DFL Trade Off A firm can trade off operating and financial leverage to control DCL. A firm with a high DOL may choose a capital structure with a low DFL to avoid a high DCL.

15 How Can You Find the Probability of EPS? Loss level of EBIT is the amount of EBIT needed to cover interest charged and preferred dividends The Z value can be looked up in Table V (Normal Distribution) Probability of negative EPS Loss level EBIT – Expected EBIT Standard deviation of EBIT Z =

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17 EBIT-EPS Analysis Technique for comparing alternative capital structures Determine the level of EBIT where EPS would be identical under either debt or equity financing: Debt financing Equity financing = NeNe (EBIT – I e ) (1 – T) – D p NdNd (EBIT – I d ) (1 - T) – D p

18 Graphical Analysis of EBIT - EPS EPS EBIT Debt Financing Equity Financing Indifference Point Advantage to debt financing Advantage to equity financing

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20 Analyze the 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.

21 Analyze the 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 Check out the glossary of risk management terms at this Web site:

22 Cash Insolvency Analysis Helps managers choose their capital structure during a recession when liquidity is important CB R = CB 0 + FCF R The firm needs cash (or access to cash) to survive a recession

23 Factors Considered in Capital Structure Decisions Tendency to cluster around industry average Need for funds Benchmark leverage ratios  By lenders and bond rating agencies  Info on ratings Managerial risk aversion Retain control