Ch. 13: Determining the Financing Mix How do we want to finance our firm’s assets? , Prentice Hall, Inc.

Determining the Financing Mix n Operating Leverage n Financial Leverage n Capital Structure

What is Leverage?

2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT).

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

Business Risk Affected by: n Sales volume variability n Competition n Cost variability n Product diversification n Product demand n Operating Leverage

Operating Leverage n The use of fixed operating costs as opposed to variable operating costs. n A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

EBIT OperatingLeverage

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders

Financial Leverage n The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

EPS Financial Leverage

Breakeven Analysis n Illustrates the effects of operating leverage. n Useful for forecasting the profitability of a firm, division or product line. n Useful for analyzing the impact of changes in fixed costs, variable costs, and sales price.

Quantity $ Breakeven Analysis

Quantity $ Total Revenue

Costs n Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

Quantity$

Quantity $ Total Revenue

Quantity { $ Total Cost FC

Quantity { $ Total Revenue Total Cost FC Q1Q1 + - } EBIT

Quantity { $ Total Revenue Total Cost FC Break-evenpoint Q1Q1 + - } EBIT

Operating Leverage n What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

Quantity { $ Total Revenue Total Cost FC Break-evenpoint Q1Q1 + - } EBIT

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Breakeven Calculations

Breakeven point (units of output) QB =QB =QB =QB = F P - V

Breakeven Calculations Breakeven point (units of output) n Q B = breakeven level of Q. n F = total anticipated fixed costs. n P = sales price per unit. n V = variable cost per unit. QB =QB =QB =QB = F P - V

Breakeven Calculations S* = F VC VC S 1 - Breakeven point (sales dollars)

n S* = breakeven level of sales. n F = total anticipated fixed costs. n S = total sales. n VC = total variable costs. Breakeven Calculations S* = F VC VC S 1 -

Analytical Income Statement sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income

sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income } contribution margin Analytical Income Statement

sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income } contribution margin Analytical Income Statement EBT (1 - t) = Net Income, EBT (1 - t) = Net Income, so, so, Net Income / (1 - t) = EBT Net Income / (1 - t) = EBT EBT (1 - t) = Net Income, EBT (1 - t) = Net Income, so, so, Net Income / (1 - t) = EBT Net Income / (1 - t) = EBT

Degree of Operating Leverage (DOL) n Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income. n This “multiplier effect” is called the degree of operating leverage.

DOLs = % change in EBIT % change in sales Degree of Operating Leverage from Sales Level (S)

DOLs = % change in EBIT % change in sales change in EBIT EBIT EBIT change in sales sales sales = Degree of Operating Leverage from Sales Level (S)

n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S)

DOLs = Sales - Variable Costs EBIT EBIT n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S)

n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) Q(P - V) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs EBIT EBIT

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

Degree of Financial Leverage (DFL) n Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share. n This “multiplier effect” is called the degree of financial leverage.

DFL = % change in EPS % change in EBIT Degree of Financial Leverage

DFL = % change in EPS % change in EBIT change in EPS EPS EPS change in EBIT EBIT EBIT Degree of Financial Leverage =

n If we have the data, we can use this formula:

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I n If we have the data, we can use this formula:

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales

Degree of Combined Leverage (DCL) n Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share. n This “multiplier effect” is called the degree of combined leverage.

Degree of Combined Leverage

DCL = DOL x DFL Degree of Combined Leverage

DCL = DOL x DFL % change in EPS % change in Sales Degree of Combined Leverage =

DCL = DOL x DFL % change in EPS % change in Sales Degree of Combined Leverage = change in EPS EPS EPS change in Sales Sales Sales =

Degree of Combined Leverage n If we have the data, we can use this formula:

DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I n If we have the data, we can use this formula: Degree of Combined Leverage

DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I n If we have the data, we can use this formula: Q(P - V) Q(P - V) Q(P - V) - F - I Q(P - V) - F - I =

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales

In-class Project: n Based on the following information on Levered Company, answer these questions: 1) If sales increase by 10%, what should happen to operating income? 2) If operating income increases by 10%, what should happen to EPS? 3) If sales increase by 10%, what should be the effect on EPS?

Levered Company Sales (100,000 units)$1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Common shares outstanding 100,000

Sales EBIT EPS DOL DFL DCL Leverage

Levered Company Sales EBIT EPS DOL = DFL DCL

Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT EBIT

Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = DOLs = Sales - Variable Costs EBIT EBIT

Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = = DOLs = Sales - Variable Costs EBIT EBIT

Levered Company Sales EBIT EPS DOL = DFL = DCL

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000 = 1.556

Levered Company Sales EBIT EPS DOL = DFL = DCL

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 =

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 = =

Levered Company Sales EBIT EPS DOL = DFL = DCL = 2.667

Sales (110,000 units)1,540,000 Sales (110,000 units)1,540,000 Variable Costs (880,000) Variable Costs (880,000) Fixed Costs (250,000) Fixed Costs (250,000) EBIT 410,000 ( %) EBIT 410,000 ( %) Interest (125,000) Interest (125,000) EBT 285,000 EBT 285,000 Taxes (34%) (96,900) Taxes (34%) (96,900) Net Income 188,100 Net Income 188,100 EPS $1.881 ( %) EPS $1.881 ( %) Levered Company 10% increase in sales

Chapter 13 - part 2 Capital Structure How do we want to finance our firm’s assets?

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity Financial Structure

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity CapitalStructure

Why is Capital Structure Important? n 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. n 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. n 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

What is the Optimal Capital Structure? n In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. n This is known as the Modigliani-Miller hypothesis, or the Independence Hypothesis: firm value is independent of capital structure.

Modigliani-Miller Hypothesis n Firm value does not depend on capital structure.

Cost of Capital kc 0% debt financial leverage 100%debt. kc = cost of equity kd = cost of debt ko = cost of capital kc = cost of equity kd = cost of debt ko = cost of capital Modigliani-Miller Hypothesis

. Cost of Capital kc kd kd 0% debt financial leverage 100%debt

. Modigliani-Miller Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt

Increasing leverage causes the cost of equity to rise. Modigliani-Miller Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt financial leverage 100%debt

kc kd Modigliani-Miller Hypothesis Cost of Capitalkcko kd 0% debt financial leverage 100%debt

n In a “perfect markets” environment, capital structure is irrelevant. n In other words, changes in capital structure do not affect firm value. Modigliani-Miller Hypothesis

2) Moderate Position n The previous hypothesis examines capital structure in a “perfect market.” n The moderate position examines capital structure under more realistic conditions. n For example, what happens if we include corporate taxes?

Remember this example? Tax effects of financing with debt with stock with debt with stock with debt EBIT 400, ,000 - interest expense 0 (50,000) EBT 400, ,000 - taxes (34%) (136,000) (119,000) EAT 264, ,000 - dividends (50,000) 0 Retained earnings 214, ,000

with stock with debt with stock with debt EBIT 400, ,000 - interest expense 0 (50,000) EBT 400, ,000 - taxes (34%) (136,000) (119,000) EAT 264, ,000 - dividends (50,000) 0 Retained earnings 214, ,000 Remember this example? Tax effects of financing with debt

Moderate Position Cost of Capital kc kd financial leverage kc kd

Moderate Position Cost of Capital kc kd financial leverage kc kd Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd financial leverage kc kd because of the tax benefit associated with debt financing. associated with debt financing. Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd financial leverage kc kd The low cost of debt reduces the cost of capital.

Moderate Position Cost of Capital kc kd financial leverage kc kd The low cost of debt reduces the cost of capital. ko

Moderate Position n So, what does the tax benefit of debt financing mean for the value of the firm? n The more debt financing used, the greater the tax benefit, and the greater the value of the firm. n So, this would mean that all firms should be financed with 100% debt, right? n Why are firms not financed with 100% debt?

Why is 100% Debt not Optimal? Bankruptcy costs: costs of financial distress. n Financing becomes difficult to get. n Customers leave due to uncertainty. n Possible restructuring or liquidation costs if bankruptcy occurs.

Agency costs: costs associated with protecting bondholders. n Bondholders (principals) lend money to the firm and expect it to be invested wisely. n Stockholders own the firm and elect the board and hire managers (agents). n Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases. Why is 100% Debt not Optimal?

Moderate Position with Bankruptcy and Agency Costs Cost of Capital financial leverage kc kd

Cost of Capital financial leverage kc kd kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kd kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs. Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital. Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko Moderate Position with Bankruptcy and Agency Costs

Capital Structure Management n EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.

Capital Structure Management n EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S

Capital Structure Management n EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: n Sell 200,000 shares of common stock at $30 per share, n Borrow $6,000,000 by issuing 10% bonds.

If we expect EBIT to be $2,000,000: Financing stock debt EBIT2,000,0002,000,000 - interest 0 (600,000) EBT2,000,0001,400,000 - taxes (40%) (800,000) (560,000) EAT1,200, ,000 # shares outst.1,000, ,000 EPS $1.20 $1.05

Financing stock debt EBIT4,000,0004,000,000 - interest 0 (600,000) EBT4,000,0003,400,000 - taxes (40%) (1,600,000) (1,360,000) EAT2,400,000 2,040,000 # shares outst.1,000, ,000 EPS $2.40 $2.55 If we expect EBIT to be $4,000,000:

n If EBIT is $2,000,000, common stock financing is best. n If EBIT is $4,000,000, debt financing is best. n So, now we need to find a breakeven EBIT where neither is better than the other.

If we choose stock financing:EPSEBIT $1m $2m $3m $4m stockfinancing

If we choose bond financing: EPS EBIT $1m $2m $3m $4mbondfinancing

Breakeven EBIT EPS EBIT $1m $2m $3m $4mbondfinancingstockfinancing

Breakeven Point n Set 2 EPS calculations equal to each other and solve for EBIT: Stock Financing Debt Financing Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S S S

Breakeven Point Stock Financing Debt Financing Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S S S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800, , , , , ,000

Breakeven Point Stock Financing Debt Financing Stock Financing Debt Financing.6 EBIT =.6 EBIT - 360,000.6 EBIT =.6 EBIT - 360, EBIT =.6 EBIT - 360, EBIT =.6 EBIT - 360, EBIT = 360, EBIT = 360,000 EBIT = $3,000,000 EBIT = $3,000,000

Breakeven EBIT EPS EBIT $1m $2m $3m $4mbondfinancingstockfinancing For EBIT up to $3 million, stock financing is best.

Breakeven EBIT EPS EBIT $1m $2m $3m $4mbondfinancingstockfinancing For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million, debt financing is best.

In-class Problem n Plan A: sell 1,200,000 shares at $10 per share ($12 million total) n Plan B: issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share ($12 million total)

Breakeven EBIT Stock Financing Levered Financing Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S S S EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200, ,000 1,200, ,000 EBIT = $1,080,000 EBIT = $1,080,000

Analytical Income Statement Stock Levered Stock Levered EBIT1,080,0001,080,000 I 0 (315,000) EBT1,080, ,000 Tax (540,000) (382,500) NI 540, ,500 Shares1,200, ,000 EPS.45.45

leveredfinancingstockfinancing EPS EBIT $.5m $1m $1.5m $2m Breakeven EBIT

For EBIT up to $1.08 m, stock financing is best. leveredfinancingstockfinancing EPS EBIT $.5m $1m $1.5m $2m Breakeven EBIT

For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m, the levered plan is best.leveredfinancingstockfinancing EPS EBIT $.5m $1m $1.5m $2m

In-class Problem n Plan A: sell 1,200,000 shares at $20 per share ($24 million total) n Plan B: issue $9.6 million in 9% debt and sell shares at $20 per share ($24 million total)

Breakeven EBIT Stock Financing Levered Financing Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S S S (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200, ,000 1,200, ,000 EBIT = $2,160,000 EBIT = $2,160,000

Analytical Income Statement Stock Levered Stock Levered EBIT2,160,0002,160,000 I 0 (864,000) EBT2,160,0001,296,000 Tax (756,000) (453,600) NI1,404, ,400 Shares1,200, ,000 EPS

Breakeven EBITleveredfinancingstockfinancing EPS EBIT $1m $2m $3m $4m

Breakeven EBIT leveredfinancing stockfinancing EPS EBIT $1m $2m $3m $4m For EBIT up to $2.16 m, stock financing is best.

Breakeven EBIT leveredfinancing stockfinancing EPSEBIT $1m $2m $3m $4m For EBIT greater than $2.16 m, the levered plan is best. For EBIT up to $2.16 m, stock financing is best.