CHAPTER 10: LEVERAGE AND CAPITAL STRUCTURE

A. OVERVIEW Definition: Leverage refers to the use of fixed assets / debt financing in capital structure to magnify ROE or EPS Types of leverages: Operating leverage: concerned with sales revenue and EBIT (operating profits) Financial leverage: concerned with EBIT and EPS Total leverage: concerned with sales revenue and EPS

Note: Think of the income statement Sales revenue Less: Cost of goods sold Gross margin Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest Earnings before taxes Less: Taxes Net income after taxes (NIAT) Less: Preferred share dividends Earnings available for common shareholders (EAC) Earnings per share B. BREAKEVEN ANALYSIS Definition: Breakeven analysis (cost-volume-profit analysis) indicates the level of operations necessary to cover all operating costs and the profitability associated with various levels of sales Definition: Operating breakeven point is the level of sales to cover all OPERATING COSTS (EBIT = 0) Approaches to find the operating break even point: 1. Algebraic 2. Graphic Algebraic: Define: P = sale price per unit VC = variable cost per unit FC = fixed cost per unit Q = sales quantity per period EBIT = (P * Q) (VC * Q) FC Goal: (a) Find Q such that EBIT = 0 (b) Find S (sales revenue) such that EBIT = 0

Formula: Q such that EBIT = 0:

Q=
S such that EBIT = 0:

FC FC = P VC GM/unit

Q=

FC GM%

Two ways to find GM%. i. Per unit: GM% = GM per unit / P ii. Total dollar: GM% = Total GM / Total revenue Total GM = (P-VC)*Q Total revenue = P*Q Example A firm has fixed operating costs of $3,000. The per unit sale price is $10, with a per unit variable cost of $4. At what point of sales (units and sales revenue) would EBIT be zero? Interpretation: At operating breakeven point (Q or S), EBIT = 0. If Q (or S) exceeds the breakeven point, EBIT > 0. If Q (or S) falls below the breakeven point, EBIT < 0.

Notes: Increasing fixed costs Breakeven point increases Increasing price Breakeven point decreases Increasing variable costs Breakeven point increases C. OPERATING LEVERAGE Motivation: If Q increases from 500 to 600, total revenue increases to $6000 and total operating cost becomes $2400. Fixed cost is $3000. EBIT becomes $600. Sale quantity increases by 1/5 and EBIT increases by 100%! Definition: The use of fixed operating costs to magnify the effects of changes in sales on the firms EBIT.

Formula: Degree of operating leverage (DOL)

DOL @ base Q =

(P * Q) - (VC * Q) (P * Q) (VC * Q) FC TR - TVC GM$ = EBIT EBIT

Example A firm has fixed operating costs of $3,000. The per unit sale price is $10, with a per unit variable cost of $4. The firm is currently selling 700 units. What is the firms DOL? Interpretation: For every 1% change in sales, EBIT changes by DOL% As long as DOL > 1, operating leverage exists Note: Impact of changing fixed costs D. FINANCIAL LEVERAGE Definition: The use of fixed FINANCIAL costs to magnify the effects of changes in EBIT on the firms EPS. Formula: Degree of financial leverage (DFL)

DFL @ base EBIT =

EBIT PD EBIT I ( ) 1 T

Interpretation For every 1% change in EBIT, EPS changes by DFL% As long as DFL > 1, financial leverage exists Example Consider the following income statement. Determine its degree of financial leverage. Sales revenue 1,700 Less: Cost of goods sold 1,000 Gross margin 700 Less: Operating expenses 330 Earnings before interest and taxes (EBIT) 370 Less: Interest 70 Earnings before taxes 300 Less: Taxes 120 Net income after taxes (NIAT) 180 Less: Preferred share dividends 10 Earnings available for common shareholders (EAC) 170 E. TOTAL LEVERAGE Definition: The use of fixed costs operating and financial - to magnify the effects of changes in sales on the firms EPS.

Formula: Degree of financial leverage (DTL)

DTL @ base Q = DOL@ base Q * DFL @base EBIT

Interpretation: For every 1% change in sales, EPS changes by DTL% Example Firm A has sales of 100,000 units at $2 per unit. Variable operating costs amount to $1.7 per unit; fixed operating costs are $6,000. Interest is $10,000 per year. Firm B has sales of 100,000 units at $2.5 per unit. Variable costs amount to $1 per unit, and fixed operating costs are $62,500. Interest is $17,000 a year. Both firms are in the 40% tax bracket and preferred dividends are $1000. Compare the leverages used by the two firms. E. A FIRMS CAPITAL STRUCTURE Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. Effective decisions can lower the cost of capital, resulting in more acceptable projects, thereby increasing the value of the firm. Modigiliani-Miller Theory (MM) demonstrated that the capital structure of a firm (in a perfect market) does not affect its value. With imperfections, MM suggests that optimal capital structure balances benefits and costs of debt financing. Major benefit of debt is the tax shield. The Tax Shield comes from the fact that interest payments on debt are treated as a pretax expense to the firm, whereas dividend payments to shareholders can only be paid with after-tax earnings. Therefore, recall equation (9.3): ki = kd (1-T) Major costs: risk of bankruptcy, increase agency costs, information asymmetry. Agency cost of debt: Lender-Borrower relationship depends on lenders expectations for firms subsequent behaviour. Incentives exist for managers acting on behalf of shareholders to take advantage of lenders. Lenders protect themselves with provisions, limiting firms ability to significantly alter its business and financial risk profile. Asymmetric information: Debt financing may allow managers to have more information about operations and future prospects than investors. May explain Pecking Order approach to capital structure: A hierarchy of financing, beginning with reinvested profits, followed by debt financing, and finally external equity financing. Debt may signal under valuation of shares. So, what is an optimal capital structure? Value of the firm is maximized when the cost of capital is minimized.

V=

EBIT (1 T ) ka

EBIT = earnings before interest and taxes T = tax rate ka = weighted average cost of capital

F. EBIT-EPS APPROACH TO CAPITAL STRUCTURE Definition: Use EPS (over a range of EBIT) as a criterion to select capital structure. Approaches: 1. Algebraic: Finding the indifference point 2. Graphic: Plot EPS vs. EBIT for various debt ratios 1. Algebraic approach Motivation: Suppose you are given two capital structures. At what range of EBIT would one debt ratio yield a higher EPS than the other? At which point of EBIT would the two capital structures give the same EPS? Answer: Find the indifference point Definition: The point of EBIT at which two capital structures would give the same EPS. Formula:

EPS =
n=number of shares

(1 T) * (EBIT I) PD n

Steps for finding indifference point: 1. Substitute all information into the equation for Structure 1 2. Substitute all information into the equation for Structure 2 3. Equate the EPS of both structures 4. Find EBIT* that causes the two equations to be equal 5. At this EBIT*, what is the EPS*? The indifference point is the pair (EBIT*, EPS*). Example: A firm is choosing between two capital structures. Find the indifference point between the two capital structures and interpret the result. Use 40% tax rate. Source Structure 1 Structure 2 Long-term debt Common equity Annual dividend $75,000 @ 16% 8,000 shares 18% $50,000 @ 15% 10,000 shares $15,000 18%

Preferred equity $10,000

G. CHOOSING A CAPITAL STRUCTURE BY VALUATION MODEL Motivation: Using EPS as a criterion does not necessarily lead to a maximization of owners wealth. Approach (steps): 1. Vary the firms probable capital structures (debt ratios) 2. (Find the probability distribution of EPS Compute the expected EPS under each scenario Compute the coefficient of variation find required return Sometimes use income statement format to find expected EPS) 3. Use CAPM to find the required return under each scenario of debt ratios 4. Find the estimated share value of the firm under each scenario of debt ratios 5. Choose the debt ratio that gives the highest share value

P0 =

EPS ks

Formula (share value): Example A firm has total assets of $8,000,000, EBIT of $1,600,000, and preferred dividends of $160,000, and is taxed at 30%. Choose the optimal capital structure with the following information. Debt ratio Cost of debt # of common shares Reqd return 0% 10% 25% 0% 6% 8% 200,000 150,000 100,000 10% 12% 14%

Exercise 1. A firm is considering two capital structures. Which structure would you recommend? Suppose the firm is certain that its EBIT will exceed $75,000. Use a 40% tax rate. Source of capital Structure A Structure B Long-term debt Common equity $100,000 at 16% coupon rate $200,000 at 17% coupon rate 4000 shares 2000 shares

2. Firm ABC makes gadgets that wholesale for $6. Variable cost is $3.5. Fixed costs are $50,000 each year. ABC pays $13,000 interest and $7,000 pf. share dividends per year. Currently, ABC is selling 30,000 gadgets a year and is taxed at 40%. Comment on the firms leverage. 3. Firm X has fixed costs of $300,000 and variable costs amounting to 40% of sales. Sales are predicted to be $600,000 with 30% chance, $900,000 with 40% chance and $1,200,000 with 30% chance. Firm X has $1 million of total assets. The book value of its common shares is $25 per share. Assume a 40% tax rate. Firm X wants to analyze 5 possible capital structures. Use the EBIT-EPS approach to analyze these possibilities and make a recommendation to Firm X. Use the valuation model to choose the optimal capital structure. Debt ratio (%) 0% 15 30 45 60 Before-tax cost of debt (%) 0.00 8.00 10.00 13.00 17.00 Required return (%) 10.0 10.5 11.6 14.0 20.0