Transcript LEVERAGE AND CAPITAL STRUCTURE

LEVERAGE AND
CAPITAL STRUCTURE
Business Risk and Financial Risk
Risk – the likely variability associated with expected
revenue streams.
► The variations in the income stream can be attributed
to:
a. The firm’s exposure to business risk
b. The firm’s decision to incur financial risk
► Business Risk – the risk that comes from the nature
of the firm’s operating activities.
► Financial Risk – the risk that comes from the
financial policy (i.e capital structure) of the firm.
►
Financial and Operating Leverage
Leverage – the extent to which a firm
relies on debt. The more debt financing a firm
uses in its capital structure, the more financial
leverage it employs.
► Operating Leverage – the incurrence of fixed
operating costs in the firm’s income stream.
► Financial
Break-even Analysis
►
►
Objective – to determine the break-even quantity of output by
studying the relationships among the firm’s cost structure,
volume of output, and operating profit.
► The break-even quantity of output results in an EBIT
level = 0
Some actual and potential applications of BEP include:
a. Capital expenditure analysis as a complementary
technique to discounted cash flow evaluation models.
b. Pricing policy
c. Labor contract negotiations
d. Evaluation of cost structure
e. Financial decision making
Break-even Analysis
►
Essential elements of the break-even model:
1.
Fixed cost – cost that do not vary in total amount as the sales
volume or the quantity of output changes. Examples:
a.
b.
c.
d.
e.
2.
Administrative salaries
Depreciation
Insurance premiums
Property taxes
Rent
Variable cost – cost that tend to vary in total as output
changes. VC are fixed per unit of output. Examples:
a.
b.
c.
d.
e.
f.
Direct materials
Direct Labor
Energy cost associated with production
Packaging
Freight-out
Sales commissions
Break-even Analysis
3.
Semivariables costs (Semifixed cost) – cost
that exhibit the joint characteristics of both FC
and VC over different ranges of output.
Examples: Salaries paid to production
supervisors.
Finding Break-even Point
►
The break-even is just a simple adaptation of
the firm’s income statement expressed as:

►
Profit (π) = Sales – (Total VC + Total FC)
3 ways to find BEP:
a. Trial and Error
1)
2)
3)
Select an arbitrary output level
Calculate the corresponding EBIT amount
When EBIT = 0, BEP has been found.
Finding Break-even Point
b. Contribution Margin Analysis
1)
2)
Contribution Margin = Unit Selling Price – Unit VC
BEP (units) =
FC
contribution margin per unit
c. Algebraic Analysis
QB
P
F
V
2) Then,
1)
= the break-even level of units sold
= the unit sales price
= the total FC for the period
= unit VC
QB =
F
P–V
Finding Break-even Point
Example:
Mutiara Corporation (MC) manufactures a
complete line of women’s dress. It sells each
dress for RM 30. The variable cost for this dress
is 70% of sales. Mutiara Corporation; incurs
fixed costs of RM 360,000, how many dress
must MC sell to breakeven?
Finding Break-even Point
Solutions:
*unit variable cost (VC) = 70% x RM 30 = RM 21
QB =
=
F
P–V
RM 360 000
RM 30 – RM 21
= 40 000 unit
Finding Break-even Point
► The
BEP in sales dollars:
 S* =
F
1 – VC
S
Example:
Sales
(-) Total VC
Revenue before FC
(-) Total FC
EBIT
$ 300 000
180 000
120 000
100 000
$ 20 000
Finding Break-even Point
Solutions:
S* =
F
1 – VC
S
= $ 100 000
1 – $ 180 000
$ 300 000
= $ 100 000
1 – 0.60
= $ 250 000
Degree of Operating Leverage
► Degree
of Operating
Leverage from the base = % change in EBIT
sales level (DOLs)
% change in Sales
Q (P – V)
Q (P – V) – F
► DOLs
=
► DOLs
= revenue before FC
EBIT
=
S – VC
S – VC – F
Degree of Operating Leverage
Example:
Avitar Corporation manufactures a line of
computer memory expansion boards used in
microcomputers. The average selling price of its
finished product is $175 per unit. The variable
cost for these same units is $115. Avitar incurs
fixed costs of $650,000 per year. Avitar
estimates the sales in next year will be 20,000
units. What is Avitar expected degree of
operating leverage?
Degree of Operating Leverage
Solutions:
DOLs =
Q (P – V)
Q (P – V) – F
=
20 000 ($ 175 – $ 115)
[20 000 ($ 175 – $ 115)] – $ 650 000
= 2.1818 times
Degree of Financial Leverage
► DFL =
► DFLEBIT
% change in EPS
% change in EBIT
=
EBIT
EBIT – I
* I = interest expense
>1
Degree of Financial Leverage
Example:
Sales
(-) total VC
Revenue before FC
(-) total FC
EBIT
(-) interest expenses
EBT
Taxes (34%)
Net Income (EAT)
$ 600,000
$ 200,000
$ 400,000
$ 200,000
$ 200,000
$ 50,000
$ 150,000
$ 51,000
$ 99,000
Degree of Financial Leverage
Solutions:
What is the degree of financial leverage?
DFLEBIT =
EBIT
EBIT – I
=
$ 200 000
$ 200 000 – $ 50 000
= 1.33 times
Combination of Operating and Financial
Leverage
► DCL =
% change in EPS
% change in Sales
► DCLs
= (DOLs) x (DFLEBIT)
► DCLs
=
Q (P – V)
Q (P – V) – F – I
Planning the Firm’s
Financing Mix
Planning the Firm’s Financing Mix
Structure – the mix of all funds source that
appear on the right side of the balance sheet.
► Capital Structure – the mix of long term sources of
funds used by the firm. Basically, this concept omits
short-term liabilities.
► Financial Structure Design – the management activity
of seeking the proper mix of all financing components
in order to minimize the cost of raising a given of funds.
► Optimal Capital Structure – the unique capital
structure that minimizes the firm’s composite cost of
long term capital.
► Financial
Planning the Firm’s Financing Mix
1.
EBIT-EPS indifference point – the level of EBIT that will
equate EPS between two difference financing plans.
EPS: Stock Plan
EPS: Bond Plan
(EBIT – I) (1 – t) – P
=
(EBIT – I) (1 – t) – P
Ss
Sb
* EBIT = earning before interest and taxes
I
= interest expenses
t
= firm income tax rate
P
= preferred dividend paid
Ss
= the number of common s/o under the stock plan
Sb
= the number of common s/o under the bond plan
Planning the Firm’s Financing Mix
2.
Projected Income Statement
Alternative 1
EBIT
XXXXXX
(-) Interest
XXXXX
EBT
XXXXXX
(-) Taxes
XXXXX
Net Income
XXXXXX
Shares
XXXXXXX
EPS*
XXX
*EPS = Net Income
Shares Outstanding
Alternative 2
XXXXXX
XXXXX
XXXXXX
XXXXX
XXXXXX
XXXXXXX
XXX
Planning the Firm’s Financing Mix
Example:
ING Berhad is financed entirely with 800,000 shares of common
stock priced at RM 5 per unit and RM 1,000,000 worth of debt
(8% 10 years bond). The company plans to raise an additional
RM 2,000,000 to finance new project and considering two
alternatives;
Alternative 1: 200,000 new common shares sold
to the public
Alternative 2: Issue 10% bond
Projected level of EBIT is at approximately RM 2,000,000.
Corporate tax rate is 28%.
Planning the Firm’s Financing Mix
Solutions:
i.
Calculate the indifference level of EBIT between two
alternatives.
* Plan Stock (alternative 1)
= Interest on bond = (1,000,000 x 8% = RM 80,000)
Unit shares = 800,000 + 200,000 = 1,000,000
*Plan Bond (alternative 2)
= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)
Unit shares = 800,000
Planning the Firm’s Financing Mix
Plan Stock
(EBIT – I) (1 – t) – P
=
Ss
(EBIT – 80,000) (1 – 0.28) – 0 =
1,000,000
0.72 EBIT – RM 57,600
=
1,000,000
576,000 EBIT – RM 46,080,000,000 =
– 144,000 EBIT
=
EBIT
=
Plan Bond
(EBIT – I) (1 – t) – P
Sb
(EBIT – 280,000) (1 – 0.28) - 0
800,000
0.72 EBIT – RM 201,600
800,000
720,000 EBIT – RM 201,600,000,000
– RM 155,520,000,000
RM 1,080,000
Planning the Firm’s Financing Mix
ii.
Prepare the projected income statement that proves EPS will be the same
regardless of the plan chosen at the EBIT level found in question (i)
Alternative 1
Alternative 2
EBIT
RM 1,080,000
RM 1,080,000
(-) Interest
80,000
280,000
EBT
1,000,000
800,000
(-) Taxes (28%)
280,000
224,000
Net Income
720,000
576,000
Shares
1,000,000
800,000
EPS*
0.72
0.72
*EPS = Net Income
Shares Outstanding
Planning the Firm’s Financing Mix
iii.
Which plan will provide the highest EPS for the EBIT
projected level?
EBIT
(-) Interest
EBT
(-) Taxes (28%)
Net Income
Shares
EPS*
*EPS = Net Income
Shares Outstanding
Alternative 1
RM 2,000,000
80,000
1,920,000
537,600
1,382,400
1,000,000
1.3824
Alternative 2
RM 2,000,000
280,000
1,720,000
481,600
1,238,400
800,000
1.548