Philippine School of Business Administration - PSBA Manila

Santos, Ephraim Santos Prof: Dr. Alfredo M. Joson,

CPA
Finman2 Tuesday- Thursday (1-2:30pm) BSA CHAIR

CHAPTER 13: Leverage and Capital Structure (Warm-Up Exercises)

13–1 Canvas Reproductions has fixed operating costs of $12,500 and variable operating costs of $10 per unit
and sells its paintings for $25 each. At what level of unit sales will the company break even in terms of EBIT?

Answer:
Q FC (P – VC)
Q $12,500 ($25 $10) 833.33, or 834 units the operating breakeven point is the level of sales at
which all fixed and variable operating costs are covered and EBIT is equal to $0

E13–2 The Great Fish Taco Corporation currently has fixed operating costs of $15,000, sells its premade tacos
for $6 per box, and incurs variable operating costs of $2.50 per box. If the firm has a potential investment that
would simultaneously raise its fixed costs to $16,500 and allow it to charge a per-box sale price of $6.50 due to
bettertextured tacos, what will the impact be on its operating breakeven point in boxes?

2.) Changing costs and the operating breakeven point

Answer: Calculate the breakeven point for the current process and the breakeven point for the new
process, and compare the two.
Current breakeven:Q1$15,000/(6 – 2.5) = 4286
New breakeven: Q2 $16,500 ($6.50 $2.50) 4,125 boxes
If Great Fish Taco Corporation makes the investment, it can lower its breakeven point by 161 (4286-4125)
boxes.

E13–3 Chico’s has sales of 15,000 units at a price of $20 per unit. The firm incurs fixed operating costs of
$30,000 and variable operating costs of $12 per unit. What is Chico’s degree of operating leverage (DOL) at a
base level of sales of 15,000 units?

3.) Risk-adjusted discount rates

Answer: Use Equation 13.5 to find the DOL at 15,000 units.
Q 15,000
P $20
VC $12
FC $30,000
DOL at 15,000 units 15,000 x ($20- $12)= $120, 000 1.33
 15,000x ( 20-12) – 30k fc= 90,000

E13–4 Parker Investments has EBIT of $20,000, interest expense of $3,000, and preferred dividends of $4,000.
If it pays taxes at a rate of 38%, what is Parker’s degree of financial leverage (DFL) at a base level of EBIT of
$20,000?

4.) DFL
Substitute EBIT $20,000, I $3,000,
Answer: PD $4,000, and the tax rate (T 0.38) into
Equation 12.7.
$20,000

DFL at $20,000 EBIT

$20,000 - 3000 - [$4,000 (1 /(1 0.38)]

20,000
$10,548 1.90

E13–5 Cobalt Industries had sales of 150,000 units at a price of $10 per unit. It faced fixed operating costs of
$250,000 and variable operating costs of $5 per unit. The company is subject to a tax rate of 38% and has a
weighted average cost of capital of 8.5%. Calculate Cobalt’s net operating profits after taxes (NOPAT), and use
it to estimate the value of the firm.

Answer: Calculate EBIT, then NOPAT and the weighted average cost of capital (WACC) for Cobalt
Industries.
EBIT (150,000 $10) $250,000 (150,000 $5) $500,000
NOPAT EBIT (1 T ) $500,000 (1 0.38) $310,000
NOPAT $310,000

Value of the firm $3,647,059

ra 0.085

What is Leverage?

In finance, leverage is a strategy that companies use to increase assets, cash flows, and returns,
though it can also magnify losses. There are two main types of leverage: financial and
operating. To increase financial leverage, a firm may borrow capital through issuing fixed-
income securities or by borrowing money directly from a lender. Operating leverage can also be
used to magnify cash flows and returns, and can be attained through increasing revenues or
profit margins. Both methods are accompanied by risk, such as insolvency, but can be very
beneficial to a business.

 
 

Financial Leverage

When a company uses debt financing, its financial leverage increases. More capital
is available to boost returns, at the cost of interest payments, which affect net
earnings.

Example 1

Bob and Jim are both looking to purchase the same house that costs $500,000. Bob
plans to make a 10% down payment and take a $450,000 mortgage for the rest of
the payment (mortgage cost is 5% annually). Jim wants to purchase the house for
$500,000 cash today. Who will realize a higher return on investment if they sell the
house for $550,000 a year from today?
   

Although Jim makes a higher profit, Bob sees a much higher return on investment because he made $27,500
profit with an investment of only $50,000 (while Jim made $50,000 profit with a $500,000 investment).

Example 2

Using the same example above, Bob and Jim realize they can only sell the house for $400,000 after a year. Who
will see a greater loss on their investment?

Now that the value of the house decreased, Bob will see a much higher percentage loss on his investment (-
245%), and a higher absolute dollar amount loss because of the cost of financing. In this instance, leverage has
resulted in an increased loss.

Financial Leverage Ratio

The financial leverage ratio is an indicator of how much debt a company is using to finance its assets. A high
ratio means the firm is highly levered (using a large amount of debt to finance its assets). A low ratio indicates
the opposite.

Example

The balance sheet of Companies XYX Inc. and XYW Inc. are as follows. Which company has a higher
financial leverage ratio?

 
 

XYX Inc.

 Total Assets = 1,100

 Equity = 800
 Financial Leverage Ratio = Total Assets / Equity = 1,100 / 800 = 1.375x

XYW Inc.

 Total Assets = 1,050

 Equity = 650
 Financial Leverage Ratio = Total Assets / Equity = 1,050 / 650 = 1.615x

Company XYW Inc. reports a higher financial leverage ratio. This indicates that the company is financing a
higher portion of its assets by using debt.

Operating Leverage

Fixed operating expenses, combined with higher revenues or profit, give a company operating leverage, which
magnifies the upside or downside of its operating profit.

 
Example

The income statement of Companies XYZ and ABC are the same. Company XYZ’s operating expenses are
variable, at 20% of revenue. Company ABC’s operating expenses are fixed at $20.

Which company will see a higher net income if revenue increases by $50?

If revenue increases by $50, Company ABC will realize a higher net income because of its operating leverage
(its operating expenses are $20 while Company XYZ’s are at $30).

     

Which company will realize a lower net income if revenue decreases by $50?

When revenue decreases by $50, Company ABC loses more due to its operating leverage, which magnifies its
losses (Company XYZ’s operating expenses were variable and adjusted to the lower revenue, while Company
ABC’s operating expenses stayed fixed).
 

Operating Leverage Formula

The operating leverage formula measures the proportion of fixed costs per unit of variable or total cost. When
comparing different companies, the same formula should be used.

Example

Company A and company B both manufacture soda pop in glass bottles. Company A produced 30,000 bottles,
which cost them $2 each. Company B produced 45,000 bottles at a price of $2.50 each. Company A pays
$20,000 in rent, and company B pays $35,000. Both companies pay an annual rent, which is their only fixed
expense. Compute the operating leverage of each company using both methods.

 
 

Step 1: Compute the total variable cost

 Company A: $2/bottle * 30,000 bottles = $60,000

 Company B: $2.50/bottle * 45,000 bottles = $112,500

Step 2: Find the fixed costs

In our example, the fixed costs are the rent expenses for each company.

 Company A: $20,000
 Company B: $35,000

Step 3: Compute the total costs

 Company A: Total variable cost + Total fixed cost = $60,000 + $20,000 = $80,000
 Company B: Total variable cost + Total fixed cost = $112,500 + $35,000 = $147,500

Step 4: Compute the operating leverages

Method 1:

Operating Leverage = Fixed costs / Variable costs

 Company A: $20,000 / $60,000 = 0.333x

 Company B: $35,000 / $112,500 = 0.311x

Method 2:

Operating Leverage = Fixed costs / Total costs

 Company A: $20,000 / $80,000 = 0.250x

 Company B: $35,000 / $147,500 = 0.237x
 

a
LEVERAGE and CAPITAL STRUCTURE

Leverage

- refers to the effects that fixed costs have on the returns that shareholders earn.

- Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result is to
multiply the potential returns from a project. At the same time, leverage will also multiply the potential
downside risk in case the investment does not pan out.

- Fixed Cost - costs that do not rise and fall with changes in a firm’s sales. This cost maybe operating costs such
as costs incurred by purchasing and operating plant equipment or they may be financial costs such as the fixed
costs of making debt payments.

- Generally, leverage magnifies both returns and risks. A firm with more leverage may earn higher returns on
average than a firm with less leverage, but the returns on the more leveraged firm will also be more volatile.

Many business risks are out of the control of managers, but not the risks associated with leverage. Managers can
limit the impact of leverage by adopting strategies that rely more heavily on variable costs than on fixed costs.

An example of this is Outsource Manufacturing.

Managers can influence leverage in their decisions about how the company raises money to operate and
because leverage can have such a large impact on a firm, the financial manager must understand how to
measure and evaluate it, particularly when making capital structure decisions.

3 Types of Leverage

 Operating leverage is concerned with the relationship between the firm’s sales revenue and its
earnings before interest and taxes (EBIT) or operating profits.
  Financial leverage is concerned with the relationship between the firm’s EBIT and its common
stock earnings per share (EPS).

 Total leverage is the combined effect of operating and financial leverage. It is concerned with
the relationship between the firm’s sales revenue and EPS.

Breakeven Analysis

Firms use Breakeven Analysis also called cost-volume-profit analysis to determine the level of operations
necessary to cover all costs and to evaluate the profitability associated with various levels of sales. The firm’s
operating breakeven point is the level of sales necessary to cover all operating costs

ALGEBRAIC APPROACH

 OPERATING LEVERAGE

-is the results from the existence of fixed costs that the firm must pay to operate
Measuring the Degree of Operating Leverage (DOL)

The DEGREE OF OPERATING LEVERAGE (DOL) is a numerical measure of the firm’s operating leverage.

Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the
percentage change in sales. Operating Leverage exist.
Fixed Costs and Operating Leverage
 Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can alter the
mix of fixed and variable costs in their operations.

 FINANCIAL LEVERAGE

 is the results from the existence of fixed financial costs that the firm must pay.
EXAMPLE:

Measuring the Degree of Financial Leverage (DFL)

-The DEGREE OF FINANCIAL LEVERAGE (DFL) is a numerical measure of the firm’s financial leverage

-Whenever the percentage change in EPS resulting from a given percentage change in EBIT is greater than the
percentage change in EBIT. Financial Leverage exist.
Formula:

 TOTAL LEVERAGE

 Use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the
firm’s earning per share.
The Firm’s Capital Structure:

• POOR CAPITAL
STRUCTURE DECISIONS = HIGH COST OF CAPITAL  LOW NPVs

• EFFECTIVE CAPITAL
STRUCTURE DECISIONS = LOW COST OF CAPITAL  HIGH NPVs

TYPES OF CAPITAL

Cost of debt is lower than the cost of other forms of financing:

• Lenders demand relatively lower returns
• Lenders have a higher priority of claim against any earnings or assets available for payments
• Tax deductibility of interest payments

EQUITY CAPITAL- remains invested in the firm indefinitely

Two basic sources of equity capital
 • Preferred Stock - Preferred stockholders have a higher claim to dividends or asset distribution than
common stockholders.
• Common Stock - Common stock is a security that represents ownership in a corporation. 

Lenders typically use ratios like:

• Debt Ratio- direct measure of the degree of indebtedness
• Times interest earned ratio- measures of the firm’s ability to meet contractual payments associated with
debt.
• Fixed payment coverage ratio

CAPITAL STRUCTURE THEORY

• Research suggests that there is an optimal capital structure range.

• It is not yet possible to provide financial managers with a precise methodology for determining a firm’s
optimal capital structure.
• A systematic approach to financing business activities through a combination of equities and liabilities.

Major benefit of debt financing is the TAX SHIELD

 TAX BENEFITS- allowing firms to deduct interest payments on debt when calculating taxable
income reduces the amount of the firm’s paid in taxes.

The cost of debt financing results from:

• Increased probability of bankruptcy
• Agency costs of the lender’s constraining the firm’s actions
• The costs associated with managers having more information about the firm’s prospects than do
investors.

 PROBABILITY OF BANKRUPTCY
• The chance that a firm will become bankrupt because of an inability to meet its obligations as they come
due depends largely on its levels of both BUSINESS RISK and FINANCIAL RISK

 BUSINESS RISK
- risk to the firm of being unable to cover its operating costs.

OPERATING = BUSINESS
LEVERAGE RISK

Aside from operating leverage two other factors affect Business Risk:
Revenue Stability and Cost Stability

o REVENUE STABILITY
-Reflects the relative variability of the firm’s sales revenue
 STABLE
-demand
-product prices = BUSINESS RISK
-revenue

VOLATILE
-demand
-product prices = BUSINESS RISK
-revenue

o COST STABILITY
-Reflects the relative predictability if input prices such as those for labor and materials.

STABLE
-input prices = BUSINESS RISK

UNSTABLE
-input prices = BUSINESS RISK

 FINANCIAL RISK
- Risk to the firm of being unable to cover required financial obligations

 TOTAL RISK
- Business and Financial risk combined

ASYMMETRIC INFORMATION
- The situation in which managers of a firm have more information about operations and future
prospects than do investors.

PECKING ORDER THEORY

- A hierarchy of financing that begins with retained earnings, which is followed by debt
financing and finally external equity financing.

SIGNALING THEORY
- A financing action by management that is believed to reflect its view of the firm’s stock
value; generally debt financing is viewed as a positive signal that management believes that
stock is “ undervalued,” and a stock issue is viewed as a negative signal that the management
believes the stock is “ overvalued.”
OPTIMAL CAPITAL STRUCTURE

• The value of a firm equals the present value of its future cash flows, it follows that the value of the firm is
maximized when the cost of capital is minimized.

• The present value of future cash flows is at its highest when the discount rate (the cost of capital) is at its
lowest.

Cost Function

1.) Cost of debt, ri,

- remains low because of the tax shield, but it slowly increases as leverage increases, to compensate
lenders for increasing risk.

2.) Cost of equity, rs,

- is above the cost of debt. It increases as financial leverage increases, but it generally increases more
rapidly than the cost of debt.

3.) Weighted average cost of capital, ra ,

- results from a weighted average of the firm’s debt and equity capital costs. As debt is substituted for
equity and as the debt ratio increases, the WACC declines because the after-tax debt cost is less than the
equity cost (ri < rs).

- Simply stated, minimizing the weighted average cost of capital allows management to undertake a
larger number of profitable projects, thereby further increasing the value of the firm.

EBIT – EPS approach to Capital Structure

 - An approach for selecting the capital structure that maximizes earnings per share (EPS) over the
expected range of earnings before interest and taxes (EBIT).

PRESENTING A FINANCING PLAN GRAPHICALLY

- we want to see how changes in EBIT lead to changes in EPS under different capital structures.

Financial breakeven point

-The level of EBIT necessary to just cover all fixed financial costs; the level of EBIT for which EPS =
$0.

Financial breakeven point formula:

= I + PD / (1 – T)

- This figure shows that each capital structure is superior to the others in terms of maximizing EPS over
certain ranges of EBIT.

- Again, the intuition behind this result is fairly straightforward. When business is booming, the best
thing for shareholders is for the firm to use a great deal of debt. The firm pays lenders a relatively low
rate of
return, and the shareholders keep the rest.
CONSIDERING RISK IN EBIT–EPS ANALYSIS

(1) The financial breakeven point

(2) The degree of financial leverage - reflected in the slope of the capital structure line: The higher the financial
breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.
(3) Further assessment of risk can be performed by using ratios. As a financial leverage increases, we expect a
corresponding decline in the firms ability to make scheduled payments.

BASIC SHORTCOMING OF EBIT–EPS ANALYSIS

 - This technique tends to concentrate on maximizing earnings rather than maximizing owner
wealth as reflected in the firms stock price.
- To select the best capital structure, firms must integrate both returns (EPS) and risk into a
valuation framework consistent with the capital structure theory.

Choosing the Optimal Capital Structure

The required return associated with a given level of financial risk can be estimated in a number of ways.

1.) Estimate the beta associated with each alternative capital structure and then to use the CAPM
framework to calculate the required return.
2.) CAPM-type approach for linking project risk and required return (RADR). It involves estimating the
required return associated with each level of financial risk, as measured by a statistic such as the
coefficient of variation of EPS.

ESTIMATING VALUE
- The value of the firm associated with alternative capital structures can be estimated by using one of
the standard valuation models.

Po = Per share value of the firm

EPS = Earnings per share
Rs = Required return