Manajemen Keuangan

Foundations of Finance
Arthur Keown
John D. Martin
J. William Petty
Determining the Finance Mix

Chapter 12
Learning Objectives
1.
2.
3.
4.
5.
Understanding the difference between risk and

financial risk.
Use the technique of break-even analysis in a variety
of analytical settings.
Distinguish among the financial concepts of operating
leverage, financial leverage, and combined leverage.
Calculate the firms degree of operating leverage,
financial leverage, and combined leverage.
Understand the concept of an optimal capital
structure.
Keown Martin Petty -
Learning Objectives
6.
7.
8.
9.
10.
Explain the main underpinnings of capital structure

theory.
Understand and be able to graph the moderate
position on capital structure importance.
Incorporate the concepts of agency costs and free
cash flow into a discussion on capital structure
management.
Use the basic tools of capital structure management.
Understand how business risk and global sales
impact the multinational firm.
Slide Contents
1.
2.
3.
4.
5.
6.
7.
8.
9.
Principles Used in this chapter

Risk
Break-even Analysis
Operating and Financial leverage
Planning the Financing Mix
Capital Structure Theory
Capital Structure Management (Basic Tools)
Capital Structure Management (Survey
Results)
Finance and the Multinational Firm
1. Principles Used in this Chapter
Principles Used in this

Chapter
Principle 1:
Principle 3:
Cash-Not Profits-Is King
Principle 7:
The Risk-Return Tradeoff We Wont Take on

Additional Risk Unless We Expect to Be
Compensated With Additional Return
The Agency Problem Managers Wont Work for

the Owners Unless Its in Their Best Interest
Principle 8:
Taxes Bias Business Solutions
2. Risk
Risk
The variability associated with expected

revenue or income streams. Such
variability may arise due to:
Choice of business line (business risk).
Choice of an operating cost structure

(operating risk).
Choice of capital structure (financial risk).

Business Risk
Business Risk is the variation in the firms

expected earnings attributable to the industry
in which the firm operates. There are four
determinants of business risk:
1.
The stability of the domestic economy
2.
The exposure to, and stability of, foreign economies
3.
Sensitivity to the business cycle, and
4.
Competitive pressures in the firms industry.
10
Operating Risk
Operating risk is the variation in the

firms operating earnings that results
from the firms cost structure (mix of
fixed and variable operating costs).
Earnings of firms with higher proportion

of fixed operating costs are more
vulnerable to change in revenues.
11
Financial Risk
Financial Risk is the variation in
earnings as a result of a firms

financing mix or proportion of financing
that requires a fixed return.
12
3. Break-even Analysis
Break-even Analysis
Break-even analysis is used to

determine the break-even quantity of a
firms output by examining the
relationships among the firms cost
structure, volume of output, and profit.
Break-even may be calculated in units or

sales dollars. Break-even point indicates
the point of sales or units at which EBIT
is equal to zero.
14
Break-even Analysis
Use of break-even model enables
the financial officer:
1.
2.
To determine the quantity of output

that must be sold to cover all operating
costs, as distinct from financial costs.
To calculate the EBIT that will be
achieved at various output levels.
15
Elements of Break-even
Model
Break-even analysis requires
information on the following:
1.
Fixed Costs
2.
Variable Costs
3.
Total Revenue
4.
Total Volume
16
Break-even analysis requires

classification of costs into two categories:
Fixed costs or indirect costs
Variable costs or direct costs
Since all costs are variable in the longrun, break-even analysis is a short-run
concept.
17
Fixed or Indirect Costs
These costs do not vary in total amount as sales

volume or the quantity of output changes.
As production volume increases, fixed costs per

unit of product falls, as fixed costs are spread over
a larger and larger quantity of output (but total
remains the same).
Fixed costs vary per unit but remain fixed in total.
The total fixed costs are generally fixed for a

specific range of output.
18
Fixed Costs
Examples:
1.
2.
3.
4.
5.
6.
Administrative salaries
Depreciation
Insurance
Lump sums spent on intermittent
advertising programs
Property taxes
Rent
19
Variable or Direct Costs
Variable costs vary as output changes.

Thus if production is increased by 5%,
total variable costs will also increase by
5%.
Total variable costs = VC x N
Where VC = Variable cost per unit
N = # of units produced and sold

20
Variable Costs
Examples:
1.
2.
3.
4.
5.
6.
Direct labor
Direct materials
Energy costs (fuel, electricity, natural gas)
associated with the production
Freight costs
Packaging
Sales commissions
21
22
Revenue
Total revenue is the total sales

dollars
Total Revenue = P x Q
P = selling price per unit

Q = quantity sold
23
Volume
The volume of output refers to the

firms level of operations and may
be indicated either as a unit
quantity or as sales dollars.
24
Break-even Point (BEP)
BEP = Point at which EBIT equals

zero
EBIT = (Sales price per unit) (units

sold)
[(variable cost per unit) (units
sold) + (total fixed cost)]
25
Break-even Point (BEP)
BEP (Units) = Total Fixed costs

(Unit sales price Unit variable cost)
BEP (dollars) = Total Fixed Costs

1 Variable cost/sales
price
26
Example
Selling price per unit is $12; Variable

cost per unit is $6; Fixed costs are
$120,000
BEP (units)
= $120,000/ ($12-$6)
= $120,000/$6
= 20,000 units
If the firm sells 20,000 units, EBIT will be

equal to zero.
27
Example
BEP (in dollars)

= 120,000
1 12/6
= 120,000/.5
= $240,000
At sales of $240,000, EBIT will be equal

to zero.
28
BEP for Pierce Grain

Company
29
Example
Selling price = $10 per unit

Variable cost = $6 per unit
Fixed cost = $100,000
BEP (Units) = Total Fixed costs
(Unit sales price Unit variable cost)
= 100000/4 = 25000
units
30
Example
BEP (dollars) = Total Fixed Costs

1 Variable cost/sales
price
BEP (in $ revenues) = $100,000/.4

=$250,000
(1-180000/300000) = 1 - .6 = .4
31
4. Operating and Financial Leverage
Operating Leverage
Operating leverage measures the

sensitivity of the firms EBIT to
fluctuation in sales, when a firm has
fixed operating costs.
If the firm has no fixed operating costs,

EBIT will change in proportion to the
change in sales.
33
Operating Leverage
Operating Leverage (OL) = % change in EBIT

% change in sales
Thus % change in EBIT

= OL X % change in sales
Where :
% change in EBIT = EBITt1 EBITt / EBITt
% Change in sales =Salest1 Salest / Salest
34
Operating Leverage
Example: If a company has an operating

leverage of 6, then what is the change in EBIT if
sales increase by 5%?
Percentage change in EBIT = Operating
leverage X Percentage change in sales = 5% x 6
= 30%
Thus if the firm increases sales by 5%, EBIT will
increase by 30%
Keown Martin Petty 35
Operating Leverage
Operating leverage is present when:
Percentage change in EBIT / Percentage

change in sales > 1.00
The greater the firms degree of

operating leverage, the more the profits
will vary in response to change in sales.
36
Operating Leverage for

Pierce Grain
37
Operating Leverage for

Pierce Grain
Due to operating leverage, even though the

sales increase by only 20%, EBIT increases
by 120%. (and vice versa, if sales dropped
by 20%, EBIT will fall by 120%; see next
slide)
If Pierce had no operating leverage (i.e. all of

its operating costs were variable), then the
increase in EBIT would have been in
proportion to increase in sales, i.e. 20%.
38
39
Financial Leverage
Financial leverage is financing a portion of the

firms assets with securities bearing a fixed
rate of return in hopes of increasing the return
to the common stockholders.
Thus, the decision to use preferred stock or

debt exposes the common stockholders to
financial risk.
Variability of EBIT is magnified by firms use of

financial leverage.
40
Three financing plans for

Pierce Grain
41
Three financing plans for

Pierce Grain
Plan A: 0% debt no financial risk

Plan B: 25% debt moderate financial risk
Plan C: 40% debt higher financial risk
See next slide for impact of financial
leverage on earnings per share (EPS). The
use of financial leverage magnifies the
impact of changes in EBIT on earnings per
share.
42
43
A firm is employing financial

leverage and exposing its owners
to financial risk when:
Percentage change in EPS divided by

Percentage change in EBIT is greater
than 1.00
44
Combined Leverage
Operating leverage causes changes in sales

revenues to cause even greater changes in
EBIT; furthermore, changes in EBIT due to
financial leverage create large variations in
both EPS and total earnings available to
common shareholders.
Not surprisingly, combining operating and

financial leverage causes rather large variations
in EPS
45
Combined Leverage
Combined Leverage = Percentage

change in EPS/Percentage change in
sales
Or combined leverage = Operating

Leverage X Financial Leverage
See table 12-6
46
Combining Operating and

Financial Leverage
47
5. Planning the Financing Mix
Capital Structure
Financial Structure
Mix of all items that appear on the righthand side of the companys balance sheet
Capital Structure
Mix of the long-term sources of funds used

by the firm
Financial Structure Current liabilities =

Capital Structure
49
Financial Structure
Designing a prudent financial structure

requires answers to the following:
1. How should a firm best divide its total fund
sources between short- and long-term
components?
2. Capital structure management: In what
proportions relative to the total should the
various forms of permanent financing be utilized?
This chapter focuses on the second question.

50
Capital Structure
Management
A firm should mix the permanent

sources of funds in a manner that will
maximize the companys stock price, or
minimize the cost of capital.
A proper mix of funds sources is called

the optimal capital structure.
51
6. Capital Structure Theory
Capital Structure Theory
Theory focuses on the effect of financial

leverage on the overall cost of capital to
the enterprise.
In other words, Can the firm affect its

overall cost of funds, either favorably or
unfavorably, by varying the mixture of
financing used?
Firms strive to minimize the cost of using

financial capital.
53
M&Ms Independence
Hypothesis
According to Modigliani & Miller,

neither the total value of the firm nor
the cost of capital is influenced by
the firm's capital structure. In other
words, the financing decision is
irrelevant!
Their conclusions were based on

restrictive assumptions (such as no
taxes, perfect or efficient markets).
54
M&Ms Independence
Hypothesis
Figure 12-5 that shows that firms

value remains the same, despite
the differences in financing mix.
55
56
M&Ms Independence
Hypothesis
Figure 12-6 shows that the firms

cost of capital remains constant,
although cost of equity rises with
increased leverage.
57
58
Extensions to
Independence Hypothesis
How is the capital structure

decision affected when we
consider:
Tax benefit on interest expense
Possibility of financial distress
Agency cost of debt

59
Impact of taxes on capital

structure
Interest expense is tax deductible.
Because interest is deductible, the use of

debt financing should result in higher
total market value for firms outstanding
securities.
Tax Shield benefit = rd(m)(t)

r = rate, m = principal, t = marginal tax
rate
60
Interest on debt is tax deductible.

==> higher the interest expense,
the taxes
lower
Thus, one would suggest that firms should

maximize Debt indeed, firms should go for
100% debt to maximize tax shield benefits!!
But, we generally do not see 100% debt in

the real world. Why not?
61
Two possible explanations are:
Bankruptcy costs
Agency costs
62
Impact of Bankruptcy on
Capital structure
The Probability that a firm will be unable to

meet its debt obligations increases with debt.
Thus probability of bankruptcy (and hence
costs) increases with increased leverage.
Threat of financial distress causes the cost of
debt to rise.
As financial conditions weaken, expected costs

of default can be large enough to outweigh the
tax shield benefit of debt financing.
63
Impact of Bankruptcy on
Capital structure
So higher debt does not lead to higher value.

After a point debt reduces the value of the firm
to shareholders.
This explains a tendency to restrain from

maximizing the use of debt.
Debt capacity indicates the maximum

proportion of debt the firm can include in its
capital structure and still maintain its lowest
composite cost of capital (see figure 12-7).
64
Agency Costs
To ensure that agent-managers act in

shareholders best interest, firms must:
1. Have proper incentives
2. Monitor decisions
-bonding the managers
-auditing financial statements
-structuring the organization in unique ways that limit
useful managerial decisions
-reviewing the costs and benefits of management
perquisites
The costs of the incentives and monitoring must

be borne by the stockholders.
Keown Martin Petty 65
Impact of Agency Costs on

Capital Structure
Capital structure management also gives rise to

agency costs. Bondholders are principals as
essentially they have given a loan to the
corporation, that is owned by shareholders.
Agency problems stem from conflicts of interest

between stockholders and bondholders. For
example, pursuing risky projects may benefit
stockholders, but may not be appreciated by
bondholders
Bondholders greatest fear is default by corporation

or misuse of funds leading to financial distress.
66
Impact of Agency Costs on

Capital Structure
Agency costs may be minimized by agreeing

to include several protective covenants in the
bond contract
Bond covenants impose costs (such as periodic

disclosure) and impose constraints (on the
type of project management can undertake,
Collateral, distribution of dividends, and limits
on further borrowing)
Thus agency costs of debt reduces the

attractiveness of debt and decreases the value
of the firm.
67
Figure 12-8 indicates the trade-offs. For

example, increasing the protective
covenants will reduce the interest cost
but increase the monitoring cost (which
is eventually borne by the
shareholders).
68
Summary of Capital
Structure Theory
Market value of levered firm

= Market value of unlevered firm
+ Present value of tax shields

- Present value of Financial distress
costs
- Present value of agency costs
69
70
7. Capital Structure
Management
(Basic Tools)
Two tools
Two basic tools used to evaluate
capital structure decisions:
EPS-EBIT Chart
Financial leverage ratios
72
EPS-EBIT Chart
Managers care about EPS as it sends an

important signal to the market about
future prospects and will affect the stock
prices.
The EPS-EBIT chart provides a way to

visualize the effects of alternative capital
structure on both the level and volatility
of the firms earning per share (EPS).
73
74
Figure 12-10
The chart shows that at a specific level of EBIT,

stock and bond plan produce different EPS
(except at the intersection point with EBIT
=$21,000 where EPS is equal to $4.25 under
both plans).
Above the intersection point, EPS will be higher

for plan with greater leverage (and vice versa).
For example, at EBIT of $30,000
EPS using bond plan = $7.25
EPS using stock plan = $6.50
75
Finding the Intersection

point
Compare EPS-stock plan versus EPS-bond plan

and solve for EBIT in the following two equations:
(EBIT-I)(1-t)-P
= (EBIT-I)(1-t)-P
Ss Sb
Ss = # of stocks under stock plan
Sb = # of stocks under bond plan
I = interest expense
P = preferred stock
76
EPS-EBIT chart is simply a tool to analyze

capital structure decision.
Thus achieving a high EPS based on high

leverage may not be the right decision.
The final decision will be made after

weighing all factors.
77
Leverage Ratios
Two ratios (as covered in chapter 4),

balance sheet leverage ratio and
coverage ratio, can be computed and
compared to industry norms.
If the ratios are significantly different

from industry average, the managers
must have a sound reason.
78
8. Capital Structure
Management
(Survey Results)
The Ten Factors
A survey of 392 corporate executives

reveals the following ten factors as
important determinants of capital structure
decision:
1.
Financial flexibility:
2.
Firms bargaining position is better if it has choices
Credit Rating:
Downgrading of credit rating will increase borrowing

costs and thus managers try to avoid anything that will
trigger credit downgrades
80
The Ten Factors

3.
Insufficient internal funds:
4.
Level of interest rates:
5.
Firms follow a pecking order for raising

funds internal funds followed by debt and
then equity.
Firms tend to borrow when interest rates are

low relative to their expectations
Interest tax savings

81
The Ten Factors

6.
Transaction costs and fees:
7.
Equity valuation:
8.
Cost of issuing equity is relatively higher than

debt, making equity a less attractive source.
If shares are undervalued, firms will like to issue

debt, and vice versa.
Competitor:
Firms from similar businesses tend to have

similar capital structures.
82
The Ten Factors

9.
Bankruptcy/distress costs:
10.
Higher existing debt will increase the likelihood

of financial distress.
Customer/supplier discomfort:
High levels of debt will increase discomfort

among customers (fearing disruption in supply)
and suppliers (fearing disruption in demand and
late/non payment on existing contracts).
83
84
9. Finance and the Multinational Firm
Finance and the Multinational

Firm: Business Risk and Global
Sales
Business risk is both multidimensional and

international, and is affected by:
1.
2.
The sensitivity of the firms product demand

to general economic conditions
The degree of competition to which the firm
is exposed
3.
Product diversification
4.
Growth prospects, and
5.
Global sales volumes and production output.
86

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Foundations of Finance

Determining the Finance Mix

Understanding the difference between risk and

Keown Martin Petty -

Explain the main underpinnings of capital structure

Keown Martin Petty -

Principles Used in this chapter

1. Principles Used in this Chapter

Principles Used in this

Cash-Not Profits-Is King

The Risk-Return Tradeoff We Wont Take on

The Agency Problem Managers Wont Work for

Taxes Bias Business Solutions

Keown Martin Petty -

The variability associated with expected

Choice of business line (business risk).

Choice of an operating cost structure

Choice of capital structure (financial risk).

Business Risk is the variation in the firms

The stability of the domestic economy

The exposure to, and stability of, foreign economies

Sensitivity to the business cycle, and

Competitive pressures in the firms industry.

Keown Martin Petty -

Operating risk is the variation in the

Earnings of firms with higher proportion

Keown Martin Petty -

earnings as a result of a firms

Keown Martin Petty -

Break-even analysis is used to

Break-even may be calculated in units or

To determine the quantity of output

Keown Martin Petty -

Break-even analysis requires

Fixed costs or indirect costs

Variable costs or direct costs

Fixed or Indirect Costs

These costs do not vary in total amount as sales

As production volume increases, fixed costs per

Fixed costs vary per unit but remain fixed in total.

The total fixed costs are generally fixed for a

Keown Martin Petty -

Variable or Direct Costs

Variable costs vary as output changes.

Total variable costs = VC x N

Where VC = Variable cost per unit

N = # of units produced and sold

Keown Martin Petty -

Total revenue is the total sales

P = selling price per unit

The volume of output refers to the

Keown Martin Petty -

Break-even Point (BEP)

BEP = Point at which EBIT equals

EBIT = (Sales price per unit) (units

Keown Martin Petty -

Break-even Point (BEP)

BEP (Units) = Total Fixed costs

BEP (dollars) = Total Fixed Costs

Selling price per unit is $12; Variable

If the firm sells 20,000 units, EBIT will be

BEP (in dollars)