Leverage and Capital Structure

Chapter 11
Leverage
and Capital
Structure
Copyright 2009 Pearson Prentice Hall. All rights reserved.
Learning Goals
1. Discuss leverage, capital structure, breakeven
analysis, the operating breakeven point, and the
effect of changing costs on it.
2. Understand operating, financial, and total leverage
and the relationship among them.
3. Describe the basic types of capital, external
assessment of capital structure, the capital structure
of non-U.S. firms, and capital structure theory.
Copyright 2009 Pearson Prentice
11-2
Learning Goals
4. Explain the optimal capital structure using a graphical
view of the firms cost of capital functions and a zerogrowth valuation model.
5. Discuss the EBIT-EPS approach to capital structure.
6. Review the return and risk of alternative capital
structures, their linkage to market value, and other
important capital structure considerations related to
capital structure.
11-3
Leverage
Leverage results from the use of fixed-cost assets or funds to
magnify returns to the firms owners.
Generally, increases in leverage result in increases in risk and
return, whereas decreases in leverage result in decreases in risk
and return.
The amount of leverage in the firms capital structurethe mix
of debt and equitycan significantly affect its value by affecting
risk and return.
11-4
Leverage (cont.)
Table 11.1 General Income Statement Format and Types
of Leverage
11-5
Breakeven Analysis
Breakeven (cost-volume-profit) analysis is used to:
determine the level of operations necessary to cover all
operating costs, and
evaluate the profitability associated with various levels of
sales.
The firms operating breakeven point (OBP) is the

level of sales necessary to cover all operating expenses.
At the OBP, operating profit (EBIT) is equal to zero.
11-6
Breakeven Analysis (cont.)

To calculate the OBP, cost of goods sold and operating expenses
must be categorized as fixed or variable.
Variable costs vary directly with the level of sales and are a
function of volume, not time.
Examples would include direct labor and shipping.
Fixed costs are a function of time and do not vary with sales
volume.
Examples would include rent and fixed overhead.
11-7
Breakeven Analysis:
Algebraic Approach
Using the following variables, the operating portion
of a firms income statement may be recast as
follows:
P
sales price per unit
sales quantity in units
FC =
fixed operating costs per period
VC =
variable operating costs per unit
Letting EBIT = 0 and solving for Q, we get:

EBIT = (P x Q) - FC - (VC x Q)
11-8
Breakeven Analysis:
Algebraic Approach (cont.)
11-9
Breakeven Analysis:
Table 11.2 Operating Leverage, Costs, and Breakeven

Analysis
11-
Breakeven Analysis:
Example: Cheryls Posters has fixed operating
costs of $2,500, a sales price of $10 per
poster, and variable costs of $5 per poster.
Find the OBP.
Q =
$2,500 = 500 posters

$10 - $5
This implies that if Cheryls sells exactly 500

posters, its revenues will just equal its costs
(EBIT = $0).
11-11
Breakeven Analysis:
We can check to verify that this is the case by
substituting as follows:
EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($10 x 500) - $2,500 - ($5 x 500)
EBIT = $5,000 - $2,500 - $2,500 = $0

11-
Breakeven Analysis:
Graphical Approach
Figure 11.1 Breakeven Analysis
11-
Breakeven Analysis: Changing Costs

and the Operating Breakeven Point
Assume that Cheryls Posters wishes to evaluate the impact

of several options: (1) increasing fixed operating costs to
$3,000, (2) increasing the sale price per unit to $12.50, (3)
increasing the variable operating cost per unit to $7.50, and
(4) simultaneously implementing all three of these changes.
11-

(1) Operating BE point = $3,000/($10-$5) = 600 units
(2) Operating BE point = $2,500/($12.50-$5) = 333 units
(3) Operating BE point = $2,500/($10-$7.50) = 1,000 units
(4) Operating BE point = $3,000/($12.50-$7.50) = 600 units
11-

Table 11.3 Sensitivity of Operating Breakeven Point
to Increases in Key Breakeven Variables
11-
Operating Leverage
Figure 11.2
Operating
Leverage
11-
Operating Leverage (cont.)

Table 11.4 The EBIT for Various Sales Levels
11-
Operating Leverage: Measuring the

Degree of Operating Leverage
The degree of operating leverage (DOL) measures the
sensitivity of changes in EBIT to changes in Sales.
A companys DOL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DOL.
Only companies that use fixed costs
in the production process will experience operating
leverage.
11-

Degree of Operating Leverage (cont)
DOL = Percentage change in EBIT
Percentage change in Sales
Applying this equation to cases 1 and 2 in Table

12.4 yields:
Case 1: DOL = (+100% +50%) = 2.0
Case 2: DOL = (-100% -50%) = 2.0
11-

Degree of Operating Leverage (cont)
A more direct formula for calculating DOL at a base
sales level, Q, is shown below.
DOL at base Sales level Q =
Q X (P VC)
Q X (P VC) FC
Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

yields the following result:
DOL at 1,000 units =
1,000 X ($10 - $5)

= 2.0
1,000 X ($10 - $5) - $2,500
11-
Operating Leverage: Fixed Costs

and Operating Leverage
Assume that Cheryls Posters exchanges a portion of its
variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales
salaries. This exchange results in a reduction in variable
costs per unit from $5.00 to $4.50 and an increase in
fixed operating costs from $2,500 to $3,000
DOL at 1,000 units =
1,000 X ($10 - $4.50)

= 2.2
1,000 X ($10 - $4.50) - $2,500
11-
Operating Leverage: Fixed Costs

and Operating Leverage (cont.)
Table 11.5 Operating Leverage and Increased Fixed Costs
11-
Financial Leverage
Financial leverage results from the presence of fixed
financial costs in the firms income stream.
Financial leverage can therefore be defined as the
potential use of fixed financial costs to magnify the
effects of changes in EBIT on the firms EPS.
The two fixed financial costs most commonly found on
the firms income statement are (1) interest on debt and
(2) preferred stock dividends.
11-
Financial Leverage (cont.)

Chen Foods, a small Oriental food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with a
10% annual coupon rate and an issue of 600 shares of $4
annual dividend preferred stock. It also has 1,000 share of
common stock outstanding.
The annual interest on the bond issue is $2,000 (10% x
$20,000). The annual dividends on the preferred stock are
$2,400 ($4/share x 600 shares).
11-
Financial Leverage (cont.)

Table 11.6 The EPS for Various EBIT Levelsa
11-
Financial Leverage: Measuring the

Degree of Financial Leverage
The degree of financial leverage (DFL) measures the
sensitivity of changes in EPS to changes in EBIT.
Like the DOL, DFL can be calculated in two different
ways: One calculation will give you a point estimate,
the other will yield an interval estimate of DFL.
Only companies that use debt or other forms of fixed
cost financing (like preferred stock) will experience
financial leverage.
11-

Degree of Financial Leverage (cont)
DFL = Percentage change in EPS
Percentage change in EBIT
Applying this equation to cases 1 and 2 in Table

12.6 yields:
Case 1: DFL = (+100% +40%) = 2.5
Case 2: DFL = (-100% -40%) = 2.5
11-

Degree of Financial Leverage (cont)
A more direct formula for calculating DFL at a base level
of EBIT is shown below.
DFL at base level EBIT =
EBIT
EBIT I [PD x 1/(1-T)]
Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

the tax rate, T = 40% yields the following result:
DFL at $10,000 EBIT =
$10,000
$10,000 $2.000 [$2,400 x 1/(1-.4)]
DFL at $10,000 EBIT = 2.5
11-
Total Leverage
Total leverage results from the combined effect
of using fixed costs, both operating and
financial, to magnify the effect of changes in
sales on the firms earnings per share.
Total leverage can therefore be viewed as the
total impact of the fixed costs in the firms
operating and financial structure.
11-
Total Leverage (cont.)

Cables Inc., a computer cable manufacturer, expects sales of
20,000 units at $5 per unit in the coming year and must meet
the following obligations: variable operating costs of $2 per
unit, fixed operating costs of $10,000, interest of $20,000,
and preferred stock dividends of $12,000. The firm is in the
40% tax bracket and has 5,000 shares of common stock
outstanding. Table 12.7 on the following slide summarizes
these figures.
11-
Total Leverage: Measuring the

Degree of Total Leverage
DTL = Percentage change in EPS
Percentage change in Sales
Applying this equation to the data Table 12.7

yields:
Degree of Total Leverage (DTL) = (300% 50%) = 6.0
11-
Total Leverage: Measuring the

Degree of Total Leverage (cont.)
A more direct formula for calculating DTL at a base level of
Sales, Q, is shown below.
DTL at base sales level =
Q x (P VC)
Q x (P VC) FC I [PD x 1/(1-T)]
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =

$20,000, PD = $12,000, and the tax rate, T = 40% yields the
following result:
DTL at 20,000 units =
20,000 X ($5 $2)
20,000 X ($5 $2) $10,000 $20,000 [$12,000 x 1/(1-.4)]
DTL at 20,000 units = $60,000/$10,000 = 6.0
11-
Total Leverage: The Relationship of Operating,

Financial and Total Leverage
The relationship between the DTL, DOL, and DFL is illustrated

in the following equation:
DTL = DOL x DFL
Applying this to our previous example we get:
DTL = 1.2 X 5.0 = 6.0
11-
Total Leverage (cont.)

Table 11.7 The Total Leverage Effect
11-
The 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.
Poor capital structure decisions can result in a high cost
of capital, thereby lowering project NPVs and making
them more unacceptable.
Effective decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects,
thereby increasing the value of the firm.
11-
Types of Capital
11-
External Assessment of Capital Structure

Table 11.8 Debt Ratios for Selected Industries and Lines of Business
(Fiscal Years Ended 4/1/05 through 3/31/06)
11-
Capital Structure of Non-U.S. Firms

In recent years, researchers have focused attention not
only on the capital structures of U.S. firms, but on the
capital structures of foreign firms as well.
In general, non-U.S. companies have much higher
degrees of indebtedness than their U.S. counterparts.
In most European and Pacific Rim countries, large
commercial banks are more actively involved in the
financing of corporate activity than has been true in the
U.S.
11-
Capital Structure
of Non-U.S. Firms (cont.)
Furthermore, banks in these countries are permitted to make
large equity investments in non-financial corporationsa
practice forbidden in the U.S.
However, similarities also exist between U.S. firms and their
foreign counterparts.
For example, the same industry patterns of capital structure tend
to be found around the world.
In addition, the capital structures of U.S.-based MNCs tend to be
similar to those of foreign-based MNCs.
11-
Capital Structure Theory

According to finance theory, firms possess a target
capital structure that will minimize its cost of capital.
Unfortunately, theory can not yet provide financial
mangers with a specific methodology to help them
determine what their firms optimal capital structure
might be.
Theoretically, however, a firms optimal capital
structure will just balance the benefits of debt financing
against its costs.
11-
Capital Structure Theory (cont.)

The major benefit of debt financing is the tax shield
provided by the federal government regarding interest
payments.
The costs of debt financing result from:
the increased probability of bankruptcy caused by debt obligations,
the agency costs resulting from lenders monitoring the firms
actions, and
the costs associated with the firms managers having more
information about the firms prospects than do investors
(asymmetric information).
11-
Capital Structure Theory:

Tax Benefits
Allowing companies to deduct interest payments when
computing taxable income lowers the amount of
corporate taxes.
This in turn increases firm cash flows and makes more
cash available to investors.
In essence, the government is subsidizing the cost of
debt financing relative to equity financing.
11-

Probability of Bankruptcy
The probability that debt obligations will lead to
bankruptcy depends on the level of a companys business
risk and financial risk.
Business risk is the risk to the firm of being unable to
cover operating costs.
In general, the higher the firms fixed costs relative to
variable costs, the greater the firms operating leverage
and business risk.
Business risk is also affected by revenue and cost stability.
11-

Probability of Bankruptcy (cont.)
The firms capital structurethe mix between debt
versus equitydirectly impacts financial leverage.
Financial leverage measures the extent to which a firm
employs fixed cost financing sources such as debt and
preferred stock.
The greater a firms financial leverage, the greater will
be its financial riskthe risk of being unable to meet
its fixed interest and preferred stock dividends.
11-
Capital Structure Theory: Agency Costs

Imposed by Lenders
When a firm borrows funds by issuing debt, the interest rate
charged by lenders is based on the lenders assessment of the risk
of the firms investments.
After obtaining the loan, the firms stockholders and/or managers
could use the funds to invest in riskier assets.
If these high risk investments pay off, the stockholders benefit
but the firms bondholders are locked in and are unable to share
in this success.
11-
Capital Structure Theory: Agency Costs

Imposed by Lenders (cont.)
To avoid this, lenders impose various
monitoring costs on the firm.
Examples would of these monitoring
costs would:
include raising the rate on future debt issues,
denying future loan requests,
imposing restrictive bond provisions.
11-

Asymmetric Information
Asymmetric information results when managers of a
firm have more information
about operations and future prospects than
do investors.
Asymmetric information can impact the firms capital
structure as follows:
Suppose management has identified an extremely lucrative
investment opportunity and needs to raise capital. Based on
this opportunity, management believes its stock is
undervalued since the investors have no information about
the investment.
11-

Asymmetric Information (cont.)
Asymmetric information results when
managers of a firm have more information
do investors.
In this case, management will raise the funds using debt
since they believe/know the stock is undervalued
(underpriced) given this information. In this case, the use of
debt is viewed as a positive signal to investors regarding the
firms prospects.
11-

Asymmetric Information (cont.)
Asymmetric information results when
managers of a firm have more information
do investors.
On the other hand, if the outlook for the firm is poor,
management will issue equity instead since they believe/know
that the price of the firms stock is overvalued (overpriced).
Issuing equity is therefore generally thought of as a negative
signal.
11-
The Optimal Capital Structure

In general, it is believed that the market value of a company is
maximized when the cost of capital (the firms discount rate) is
minimized.
The value of the firm can be defined algebraically as follows:
11-
The Optimal Capital Structure

Figure 11.3
Cost Functions
and Value
11-
Figure 11.4 Graphic Presentation

of a Financing Plan
11-
Table 11.9 Basic Information on JSG

Companys Current and Alternative Capital
Structures
11-
EPS-EBIT Approach
to Capital Structure
The EPS-EBIT approach to capital structure involves selecting
the capital structure that maximizes EPS over the expected range
of EBIT.
Using this approach, the emphasis is on maximizing the owners
returns (EPS).
A major shortcoming of this approach is the fact that earnings
are only one of the determinants of shareholder wealth
maximization.
This method does not explicitly consider the impact of risk.
11-
EPS-EBIT Approach
to Capital Structure (cont.)
Example
EBIT-EPS coordinates can be found by assuming specific
EBIT values and calculating the EPS associated with them.
Such calculations for three capital structuresdebt ratios of
0%, 30%, and 60%for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.
11-
EPS-EBIT Approach
to Capital Structure (cont.)
Figure 11.5
EBITEPS
Approach
11-
Table 11.10 Calculation of Share Value

Estimates Associated with Alternative Capital
Structures for JSG Company
11-
Basic Shortcoming
of EPS-EBIT Analysis
Although EPS maximization is generally good for the
firms shareholders, the basic shortcoming of this
method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
Unfortunately, this is not the case.
11-
Choosing the Optimal Capital Structure

The following discussion will attempt to create a framework
for making capital budgeting decisions that maximizes
shareholder wealthi.e., considers both risk and return.
Perhaps the best way to demonstrate this is through the
following example:
Cooke Company, using as risk measures the
coefficients of variation of EPS associated with each
of seven alternative capital structures, estimated the
associated returns as shown in Table 12.14
11-
Choosing the Optimal

Capital Structure (cont.)
By substituting the level of EPS and the associated
required return into Equation 12.12, we can
estimate the per share value of the firm, P0.
11-
Choosing the Optimal

Capital Structure (cont.)
Figure 11.6
Estimating Value
11-
Table 11.11 Important Factors to Consider

in Making Capital Structure Decisions
11-

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Chapter 11

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The firms operating breakeven point (OBP) is the

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Breakeven Analysis (cont.)

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sales price per unit

sales quantity in units

fixed operating costs per period

variable operating costs per unit

Letting EBIT = 0 and solving for Q, we get:

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Table 11.2 Operating Leverage, Costs, and Breakeven

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$2,500 = 500 posters

This implies that if Cheryls sells exactly 500

EBIT = $5,000 - $2,500 - $2,500 = $0

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Breakeven Analysis: Changing Costs

Assume that Cheryls Posters wishes to evaluate the impact

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Breakeven Analysis: Changing Costs

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Breakeven Analysis: Changing Costs

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Operating Leverage (cont.)

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Operating Leverage: Measuring the

Operating Leverage: Measuring the

Applying this equation to cases 1 and 2 in Table

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Operating Leverage: Measuring the

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500

1,000 X ($10 - $5)

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Operating Leverage: Fixed Costs

1,000 X ($10 - $4.50)

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Operating Leverage: Fixed Costs

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Financial Leverage (cont.)

Financial Leverage (cont.)

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Financial Leverage: Measuring the

Financial Leverage: Measuring the

Applying this equation to cases 1 and 2 in Table

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Financial Leverage: Measuring the

Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and

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Total Leverage (cont.)

Total Leverage: Measuring the

Applying this equation to the data Table 12.7

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Total Leverage: Measuring the

Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I =

DTL at 20,000 units = $60,000/$10,000 = 6.0

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Total Leverage: The Relationship of Operating,