1. Lecture Note Prof. Roy Sembel, PhD Leverage and Capital Structure

2. PROF. ROY SEMBEL EDUCATION 1982-86IPB, Bogor. FMIPA. Major: Statistics, Minor: Economics; Ir., Best Graduate, Cum Laude 1988-90Rotterdam School of Management, Erasmus University Rotterdam and The Wharton School, University of Pennsylvania Philadelphia MBA, Finance/Banking, Best Graduate, With Honours 1991-96J.M.Katz Graduate School of Business, University of Pittsburgh; Major: Corporate Finance; Minor: Econometrics; PhD; Dissertation: “IPO Anomalies, Truncated Excess Supply, and Heterogeneous Information” 1997-98Economics & Finance Staff, Office of Dr (HC) Radius Prawiro, Jakarta. 2000ACUCA Lecturer: Japan, South Korea, Taiwan, Hong Kong, The Philippines, Thailand 1987-Now Lecturer, Faculty of Economics, Christian University of Indonesia, Jakarta. 1997-2001 Visiting Lecturer at IPMI, Institut PPM, Magister Management Program University of Indonesia, University of Sam Ratulangi, Universitas Lampung, Magister Akuntansi & Post Graduate (S2 & S3) Program Faculty of Economics University of Indonesia, Pelita Harapan University. Subjects: Investment Analysis and Risk Management, Corporate Finance, International Finance, Derivative Securities, Managerial Economics, Banks & Capital Markets, eBusiness Management. WORK EXPERIENCE 1984-87Teaching Assistant, FMIPA, IPB. 1990Internship; ABN Bank, European Treasury Department, Amsterdam. 1990-91Corporate Banking; ABN AMRO Bank Amsterdam 1994-96Teaching Assistant, University of Pittsburgh. 1994-2000 Co-founder Indonesian Physics Olympic Team /TOFI Foundation & Indonesian Computer Olympic Foundation TOKI

3. 1998-2001 McKinsey & Co, Jakarta 2001-2006 Direktur Program Magister Manajemen Keuangan Universitas Bina Nusantara, Co-founder Indonesia Learning Institute (InLIne), Indonesia School of Life (InSchoOL) 2005-2007 Komisaris Independen & Ketua Komite Pemantau Risiko PT Bank Niaga Tbk 2005-Professor in Financial Economics; Charter member Lembaga Komisaris dan Direksi Indonesia 2006-2008 Academic Expert Advisor, Universitas Ciputra Surabaya, 2006-Owner/Komisaris (PT. Mobee Indonesia, PT MARS Indonesia) 2007-Supervisory Committee Asian Bond Fund Indonesia (TCW Bahana/BI), Ketua Komite Sertifikasi FPSB Indonesia 2007-2008 Pejabat Dekan FE Universitas Multimedia Nusantara (UMN) Ketua Umum Partai Barisan Nasional (BARNAS) 2008Board of Advisor UMN 2008-Ketua Dewan Pembina Partai Barisan Nasional (BARNAS) Chief Research Officer CAPITAL PRICE 2009-Dean of Business School and Director of Graduate Program, UPH MISCELLANEOUS Speaker in many seminars in Indonesia, USA, and Europe. Writer of more than 1000 articles in KONTAN, GATRA, Sinar Harapan, SWA, Bisnis Indonesia, KOMPAS, Investor, Investor Daily, Warta Ekonomi, Manajemen & Usahawan Indonesia, InfoBank, Jurnal Pasar Modal, Media Akuntansi, DIA, Bahana, Jurnal Ekonomi UKI, JAKI, JBR, Scripta Economica UPH, Jurnal, Sinergi MMUII, published books, Internet.

4. Learning Objectives  Break-even level of sales.  Operating and financial leverage and risk.  Risks and returns of leveraged buy-outs.  Affect of capital structure on value.

5. Break-even Analysis Steps to Solution  Construct a chart to find the sales break-even point = level of sales necessary to cover operating (not financial) costs.  This requires that you calculate EBIT for different unit sales amounts.  The point at which EBIT = 0 is the break-even level of sales.

6. Break-even Analysis Assumptions  Fixed costs remain constant as quantity changes.  Variable costs vary as quantity of output changes: they are constant per unit of output. Quantity Sold Costs $ Fixed Costs Variable Costs

7. Fixed vs. Variable Costs  Fixed costs may include salaries, depreciation, rent.  Variable costs may include commissions, materials, labor.

8. Break-even Analysis  Calculation of Break-even Quantity EBIT = Sales – Variable Costs - Fixed Costs Find Quantity which results in EBIT = $0

9. Break-even Analysis  Calculation of Break-even Quantity Unit Sales be = FC p – vc Where: Unit Sales be = Break-even quantity FC = Total fixed costs p = Sales price per unit vc = Variable costs per unit

10. Break-even Analysis  Calculation of Break-even Quantity Unit Sales be = FC p – vc Example: Fixed Costs=$1,000,000/year Price=$800/unit Variable Costs=$400/unit

11. Break-even Analysis  Calculation of Break-even Quantity Unit Sales be = FC p – vc Example: Fixed Costs=$1,000,000/year Price=$800/unit Variable Costs=$400/unit $1,000,000 $800 – $400 = = 2,500 units

12. Break-even Analysis  Now calculate total revenue. TR = p x Q p = Sales price per unit Q = unit sales

13. Break-even Analysis  Calculate total revenue for different levels of sales. TR = p x Q Unit sales (Q) xPrice (p)= Total Revenue (TR) 0 x $800=$0 500 x $800=$ 400,000 1,000 x $800= $ 800,000 2,000 x $800=$1,600,000 2,500 x $800=$2,000,000

14. Break-even Analysis-Graph  Graphical Analysis of Break-even Point Quantity of Units Sales & Costs $ Fixed Costs $1,000,000 Variable Costs

15. Break-even Analysis-Graph  Graphical Analysis of Break-even Point Quantity of Units Sales & Costs $ Fixed Costs $1,000,000 Total Costs Variable Costs

16. Break-even Analysis-Graph  Graphical Analysis of Break-even Point Quantity of Units Sales & Costs $ Fixed Costs $1,000,000 Total Costs Sales Variable Costs

17. Break-even Analysis-Graph  Graphical Analysis of Break-even Point Quantity of Units Sales & Costs $ Fixed Costs $1,000,000 Total Costs Variable Costs Sales Q be = 2,500 $2,000,000

18. The Concept of Leverage You cannot easily move a large boulder.

19. The Concept of Leverage However, with the aid of a lever you can move an object many times your size.

20. The Concept of Leverage The longer the lever, the bigger the rock you can move.

21. The Concept of Leverage  In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance.  Operating leverage occurs due to fixed costs in the production process.  With high fixed costs, a small change in sales may trigger a large change in operating income (EBIT).

22. Operating Leverage  Measurement of Operating Leverage  Degree of Operating Leverage (DOL)  DOL > 1 means the firm has operating leverage. DOL = % Change in EBIT % Change in Sales

23. Operating Leverage DOL = % Change in EBIT % Change in Sales Example: fixed costs = $1 and no variable costs EBIT for Sales of $3 = $3 - $1 = $2 EBIT for Sales of $4 = $4 - $1 = $3 ($3 - $2)/$2.50 ($4 - $3)/$3.33 DOL == = 1.5

24. Operating Leverage  Measurement of DOL  Calculation using per unit information: DOL = Sales - Total VC Sales-Total VC-FC

25. Operating Leverage  Measurement of DOL  Calculation using per unit information: DOL = Sales - Total VC Sales-Total VC-FC Q=3,750 units P=$800 per unit VC=$400 per unit FC=$1,000,000 per year. Example:

26. Operating Leverage  Measurement of DOL  Calculation using per unit information: DOL 3,750 units = 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000 DOL = Sales - Total VC Sales-Total VC-FC

27. Operating Leverage  Measurement of DOL  Calculation using per unit information: DOL 3,750 units = =3 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000 DOL = Sales - Total VC Sales-Total VC-FC Interpretation: If sales change 1%, then EBIT will change 3% (same direction).

28. Operating Leverage  Degree of Operating Leverage falls as sales rise QuantityDOL 2,500 (Q be )Undefined 3,2504.33 3,7503 5,0002

29. Operating Leverage  Degree of Operating Leverage falls as sales rise QuantityDOL 2,500 (Q be )Undefined 3,2504.33 3,7503 5,0002  The higher the sales level above break-even, the less EBIT changes as sales change  If FC = $0, DOL = 1

30. Financial Leverage  Degree of Financial Leverage

31. Financial Leverage  Degree of Financial Leverage  Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock

32. Financial Leverage  Degree of Financial Leverage  Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock  Financial Leverage measures changes in earnings per share as EBIT changes.

33. Financial Leverage  Degree of Financial Leverage  Finance a portion of the firm’s assets with securities that have fixed financial costs Debt Preferred Stock  Financial Leverage measures changes in earnings per share as EBIT changes. DFL EBIT = % Change in NI % Change in EBIT Unique Level of EBIT

34. Financial Leverage DFL EBIT = EBIT EBIT – I  Measurement of DFL (Alternative formula)  If DFL > 1, the firm has financial leverage. An increase in EBIT wil result in a larger increase in NI.

35. Financial Leverage EBIT =$500,000 Interest Charges=$200,000 Example:

36. Financial Leverage EBIT =$500,000 Interest Charges=$200,000 Example: DFL EBIT=500,000 = 500,000 500,000 – 200,000 = 1.67 times

37. Financial Leverage EBIT =$500,000 Interest Charges=$200,000 Example: DFL EBIT=500,000 = 500,000 500,000 – 200,000 = 1.67 times Interpretation: When EBIT changes 1% (from an existing level of $500,000) Earnings Per Share will change 1.67%

38. Combined Leverage  Degree of Combined Leverage  Measures changes in Net Income given changes in Sales

39. Combined Leverage  Degree of Combined Leverage  Measures changes in Net Income given changes in Sales  Combines both Operating and Financial Leverage

40. Combined Leverage  Degree of Combined Leverage  Measures changes in Net Income given changes in Sales  Combines both Operating and Financial Leverage  Computed for a specific level of sales

41. Combined Leverage DCL S = % Change in EPS % Change in Sales  Degree of Combined Leverage  Measures changes in Net Income given changes in Sales  Combines both Operating and Financial Leverage  Computed for a specific level of sales Unique Level of Sales

42. Combined Leverage DCL S = DOL S x DFL EBIT DFL EBIT = 1.67 DOL S =3.0 Example:

43. Combined Leverage DCL S = DOL S x DFL EBIT DFL EBIT = 1.67 DOL S =3.0 Example: = 5.0 times DCL 3,750 = 3.0 x 1.67

44. Combined Leverage DCL S = DOL S x DFL EBIT DFL EBIT = 1.67 DOL S =3.0 Example: = 5.0 times Interpretation: When sales change 1%, Net Income will change 5.0% DCL 3,750 = 3.0 x 1.67

45. Effect of Leverage  Leverage can help the firm or hurt it.  If EBIT increases, leverage will cause net income to increase even more.  If EBIT decreases, leverage will cause a larger decline in net income.

46. Capital Structure Theory  Capital Structure is the mixture of sources of funds a firm uses.  Debt  Preferred Stock  Common Stock

47. Capital Structure Theory  A benefit of debt financing is that interest is tax deductible whereas payments to equity providers are not.  Firms must trade off this benefit against the increased financial risk associated with higher debt levels.

48. Capital Structure Theory -Modigliani and Miller (MM)  MM wrote an important paper in 1958 in which they proved that with tax deductibility of interest payments, the optimal capital structure is 100% debt.  Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations.

49. Financial Leverage, EPS, and ROE Current Assets$20,000 Debt$0 Equity$20,000 Debt/Equity ratio0.00 Interest raten/a Shares outstanding400 Share price$50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)

50. EPS and ROE Under Current Capital Structure RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 Net income$1,000$2,000$3,000 EPS$2.50$5.00$7.50 ROA5%10%15% ROE5%10%15% Current Shares Outstanding = 400 shares

51. EPS and ROE Under Proposed Capital Structure RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares

52. EPS and ROE Under Both Capital Structures Levered RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest640640640 Net income$360$1,360$2,360 EPS$1.50$5.67$9.83 ROA5%10%15% ROE3%11%20% Proposed Shares Outstanding = 240 shares All-Equity RecessionExpectedExpansion EBIT$1,000$2,000$3,000 Interest000 Net income$1,000$2,000$3,000 EPS$2.50$5.00$7.50 ROA5%10%15% ROE5%10%15% Current Shares Outstanding = 400 shares

53. Financial Leverage and EPS (2.00) 0.00 2.00 4.00 6.00 8.00 10.00 12.00 1,0002,0003,000 EPS Debt No Debt Break-even point EBI in dollars, no taxes Advantage to debt Disadvantage to debt EBIT

54. Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes The levered firm pays less in taxes than does the all- equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm. SGSG B All-equity firm Levered firm

55. Integration of Tax Effects and Financial Distress Costs Debt (B) Value of firm (V) 0 Present value of tax shield on debt Present value of financial distress costs Value of firm under MM with corporate taxes and debt V L = V U + T C B V = Actual value of firm V U = Value of firm with no debt B* Maximum firm value  Because costs of financial distress can be reduced but not eliminated, firms will not finance entirely with debt. Optimal amount of debt

56. Capital Structure in the Real World  Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.  Affect on costs of capital:

57. Capital Structure in the Real World  Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.  Affect on costs of capital:  Since debt is cheaper than equity, use of debt will initially lower the WACC.  At high levels of debt, the WACC will increase as investors perceive the firm to be riskier.