1. Determining the Financing Mix Chapter 12 Foundations of Finance Keown, Martin, Petty

2. Target Capital Structure Definition – The target capital structure is defined as the particular mix of debt, preferred stock and common equity that will maximize firm’s stock price while also minimizing the company’s WACC Capital structure policy involves a trade-off between risk and return. 1.Using more debt raises the risk borne by stockholders. 2.However using more debt generally increases the expected ROE.

3. Understanding the Difference between Business Risk and Financial Risk ultimately leading to a decrease in firm’s stock price. cause investors to revise their expectations regarding firm’s future prospects as low earnings worried about earnings they report Firm’s executives

4. Why Firm’s Income Stream show variations over different periods For example if the business operates in a highly volatile industry in which revenues fluctuate with business cycle. Choice of Business Line Greater fixed operating cost increases variability in operating earnings in response to changes in revenues. This source of variation in firm’s earning referred to as Operating Risk. Choice of an operating cost structure Source of variation in firm’s earnings that arises from firm’s use of debt known as Financial Risk. Choice of capital structure

5. Business Risk Definition – Risk of firm’s future earnings that is a direct result of the particular line of business chosen by the firm. Four basic determinants of Business Risk.

6. Operating Leverage Definition – Operating leverage can be defined as the degree to which a company uses fixed cost in its operations. – Higher the fixed cost of a company as a % of total cost higher the operating leverage. – For companies with high operating leverage a small change in company’s revenues (PxQ) will bring a large change in operating income (EBIT) as most of the costs are fixed rather than variable.

7. Operating Leverage Example Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost) Normal economic Conditions. Q=10,000 and P=20/unit Company A Robotic VC=8/unit FC = 60,000 Company B Manual VC=14/unit FC = 20,000 Sales (PxQ)200,000Sales (PxQ)200,000 Variable cost (VCxQ)80,000Variable cost (VCxQ)140,000 Fixed cost60,000Fixed cost20,000 EBIT60,000EBIT40,000

8. Operating Leverage Example Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost) Economic conditions suddenly improve, Demand greatly increases for this type of product. Q=30,000 and P=20/unit Company A Robotic VC=8/unit FC = 60,000 Company B Manual VC=14/unit FC = 20,000 Sales (PxQ)600,000Sales (PxQ)600,000 Variable cost (VCxQ)240,000Variable cost (VCxQ)420,000 Fixed cost60,000Fixed cost20,000 EBIT300,000EBIT160,000

9. Operating Leverage We can see that whenever Revenues of an organization increase the impact felt on the EBIT of an organization with greater fixed cost in its operations will be much greater than an organization with lower fixed cost built in its operations. This is because for Company A, a greater portion of cost is fixed so as Sales increase no great impact on total operating cost is produced which leads to a greater EBIT. However, for Company B, a greater portion of cost is variable so as Revenues increase (Q increases), V.C. (increases) and a greater impact felt on total operating cost leading to a decreased EBIT.

10. Operating Leverage Example Company A is robotic (high Fixed cost) while Company B is manual (low fixed cost) Economic conditions take a downhill. Q=1000 and P=20/unit Company A Robotic VC=8/unit FC = 60,000 Company B Manual VC=14/unit FC = 20,000 Sales (PxQ)20,000Sales (PxQ)20,000 Variable cost (VCxQ)8000Variable cost (VCxQ)14000 Fixed cost60,000Fixed cost20,000 EBIT(48000)EBIT(14000)

11. Operating Leverage DOL = Contribution margin/(RBFC) Net op. income (EBIT)

12. Operating Leverage Example This data shows a 10% increase in sales volume leads to a 40% increase in EBIT for Company A while a 70% increase is seen in Company B as for Company B a greater portion of cost is fixed. First Income Statement Company A$%Company B$% Sales100,000100Sales100,000100 Variable cost-60,000-60Variable cost-30,000-30 RBFC (CM)40,00040RBFC (CM)70,00070 Fixed cost-30,000Fixed cost-60,000 EBIT10,000EBIT10,000 Second Income Statement Company A$%Company B$% Sales110,000100Sales110,000100 Variable cost-66,000-60Variable cost-33,000-30 RBFC (CM)44,00040RBFC (CM)77,00070 Fixed cost-30,000Fixed cost-60,000 EBIT14,000EBIT17,000

13. Operating Leverage Example First Income Statement Company A$%Company B$% Sales100,000100Sales100,000100 Variable cost-60,000-60Variable cost-30,000-30 RBFC (CM)40,00040RBFC (CM)70,00070 Fixed cost-30,000Fixed cost-60,000 EBIT10,000EBIT10,000 Second Income Statement Company A$%Company B$% Sales110,000100Sales110,000100 Variable cost-66,000-60Variable cost-33,000-30 RBFC (CM)44,00040RBFC (CM)77,00070 Fixed cost-30,000Fixed cost-60,000 EBIT14,000EBIT17,000 DOLCo. ACo. B CM/EBIT40,000/10,000 = 470,000/10,000 = 7 % increase in sales = 10% Impact on EBIT4x10% = 40%7x10% = 70%

14. Operating Leverage Importance

15. Financial Leverage Definition – The additional risk stockholders face when the company decides to use debt as a source of financing. Financial leverage can be defined as the extent to which company uses fixed income securities such as debt. With high degree of financial leverage comes high interest payment. As a result the bottom-line EPS is negatively impacted by interest payments.

16. Financial Leverage

17. Breakeven Point Definition – Breakeven point is the level of sales at which profit is zero. At Breakeven point sales are equal to fixed cost plus variable cost. Number of units at which EBIT = 0