Transcript No Slide Title

Chapter
13
Capital Structure
Management in Practice
Copyright ©2003 South-Western/Thomson Learning
Introduction
• This chapter focuses on tools of
analysis that can assist managers in
making capital structure decisions
that will lead to a maximization of
shareholder wealth.
• It develops techniques, derived from
accounting data, for measuring
operating and financial leverage.
Operating and Financial Leverage
• Leverage
– A firm’s use of assets and liabilities having
fixed costs in an attempt to increase
potential returns to stockholders
• Operating leverage
– The use of assets having fixed costs
• Financial leverage
– The use of liabilities (and preferred stock)
having fixed costs
Various Categories of Costs
• From fixed operating or fixed capital
costs
• Operating costs
– Costs of sales
– General, administrative, and selling
expenses
• Capital costs
– Interest charges
– Preferred dividends
– Income taxes
Short-Run Costs
• Over the short run, certain operating
costs within a firm vary directly with the
level of sales whereas other costs
remain constant, regardless of changes
in the sales level. Costs that move in
close relationship to changes in sales
are called variable costs.
Short-Run Costs
• Variable costs are tied to the number of
units produced and sold by the firm,
rather than to the passage of time. They
include raw material and direct labor
costs, as well as sales commissions.
Short-Run Costs
• Over the short run, certain other
operating costs are independent of sales
or output levels. These, termed fixed
costs, are primarily related to the
passage of time. Depreciation on
property, plant, and equipment; rent;
insurance; lighting and heating bills;
property taxes; and the salaries of
management are all usually considered
fixed costs.
Short-Run Costs
• If a firm expects to keep functioning, it
must continue to pay these fixed costs,
regardless of the sales level.
Short-Run Costs
• A third category, semivariable costs, can
also be considered. Semivariable costs
are costs that increase in a stepwise
manner as output is increased. One cost
that sometimes behaves in a stepwise
manner is management salaries.
Short-Run Costs
• Whereas semivariable costs are
generally considered fixed, this
assumption is not always valid. A firm
faced with declining sales and profits
during an economic downturn may often
cut the size of its managerial staff.
Short-Run Costs
• Panels (a), (b), and (c) of Figure 13.1
show the behavior of variable, fixed, and
semivariable costs, respectively, over the
firm’s output range.
Long-Run Costs
• Over the long run, all costs are variable.
In time, a firm can change the size of its
physical facilities and number of
management personnel in response to
changes in the level of sales. Fixed
capital costs also can be changed in the
long run.
Operating and Financial Leverage
• Operating leverage has fixed operating
costs for its “fulcrum.” When a firm incurs
fixed operating costs, a change in sales
revenue is magnified into a relatively
larger change in earnings before interest
and taxes (EBIT). The multiplier effect
resulting from the use of fixed operating
costs is known as the degree of
operating leverage.
Operating and Financial Leverage
• Financial leverage has fixed capital
costs for its “fulcrum.” When a firm incurs
fixed capital costs, a change in EBIT is
magnified into a larger change in
earnings per share (EPS). The multiplier
effect resulting from the use of fixed
capital costs is known as the degree of
financial leverage.
Leverage Model
%

Sales
DOL
% EBIT
DFL
% EPS
Degree of Operating Leverage
• A firm’s degree of operating leverage
(DOL) is defined as the multiplier effect
resulting from the firm’s use of fixed
operating costs. More specifically, DOL
can be computed as the percentage
change in earnings before interest and
taxes (EBIT) resulting from a given
percentage change in sales (output):
Percentage change in EBIT
DOL 
Percentage change in sales
Degree of Operating Leverage
• The formula in the previous slide can be
rewritten as follows (13.1):
EBIT EBITt +1  EBITt
EBITt
EBIT
DOL at X 

Sales Sales t +1  Sales t
Sales
Salet
where ΔEBIT and ΔSales are the
changes in the firm’s EBIT and sales,
respectively.
Degree of Operating Leverage
• Because a firm’s DOL differs at each
sales (output) level, it is necessary to
indicate the sales (units of output or
dollar sales) point X, at which operating
leverage is measured.
Degree of Operating Leverage
• The degree of operating leverage is
analogous to the elasticity concept of
economics (for example, price and
income elasticity) in that it relates
percentage changes in one variable
(EBIT) to percentage changes in another
variable (sales).
Degree of Operating Leverage
TABLE 13.1 Traditional and Revised Income Statements, Allegan
Manufacturing Company, Year Ending December 31, 20X1
Traditional Income Statement Format
Sales
$5,000,00
Operating Less Cost of sales
$2,500,000
leverage
Selling, administrative, and general
1,500,000
expenses
Total operating costs
4,000,00
------------ Earnings before interest and taxes (EBIT)
1,000,00
Less Interest expense
250,00
Earnings before taxes (EBT)
750,00
Financial Less Income taxes (40% rate)
300,00
leverage
Earnings after taxes (EAT)
450,00
Less Preferred stock dividends
150,00
Earnings available to common stockholders
$300,00
------------ Earnings per share (EPS) – 100,000 shares
$3.0
Degree of Operating Leverage
TABLE 13.1
Continued
Revised Income Statement Format
Sales
Operating Less Variable operating costs
$3,000,000
leverage
Fixed operating costs
1,000,000
Total operating costs
------------ Earnings before interest and taxes (EBIT)
Less Fixed capital costs (interest)
Earnings before taxes (EBT)
Financial Less Income taxes (variable), 40% rate
leverage
Earnings after taxes (EAT)
Less Fixed capital costs (preferred stock
dividends)
Earnings available to common stockholders
------------ Earnings per share (EPS) – 100,000 shares
$5,000,00
4,000,00
1,000,00
250,00
750,00
300,00
450,00
150,00
$300,00
$3.0
Degree of Operating Leverage
• The calculation of the DOL can be
illustrated using the Allegan
Manufacturing Company example in
Table 13.1. Since Allegan’s variable
operating costs were $3 million at the
current sales level of $5 million.
Therefore, the firm’s variable operating
cost ratio is ($3 million)/($5 million) =
0.60, or 60 percent.
Degree of Operating Leverage
• Suppose the firm increased sales by 10
percent to $5.5 million while keeping
fixed operating costs constant at $1
million and the variable (operating) cost
ratio at 60 percent. As can be seen in
Table 13.2, this would increase the firm’s
earnings before interest and taxes
(EBIT) to $1.2 million.
Degree of Operating Leverage
TABLE 13.2 Effect of Earnings per Share of a 10 Percent Increase in Sales, Allegan
Manufacturing Company, Year Ending December 31, 20X1
(1)
Sales
Less Variable operating costs (0.6*Sales)
Fixed operating costs
$5,000,000
(2)
[(2) – (1)] / (1)
$5,500,000
+10%
($3,000,000) ($3,300,000)
+10%
(1,000,000)
(1,000,000)
0%
(4,000,000)
(4,300,000)
+8%
$1,000,000
$1,200,000
+20%
250,000
250,000
0%
$750,000
$950,000
+27%
300,000
380,000
+27%
$450,000
$570,000
+27%
Less Preferred dividends (fixed capital cost)
150,000
150,000
0%
Earnings available to common stockholders
$300,000
$420,000
+40%
$3.00
$4.20
+40%
Total operating costs
Earnings before interest and taxes
Less Interest payments (fixed capital cost)
Earnings before taxes
Less Income taxes (variable), 40%
Earnings after taxes
Earnings per share (100,000 shares)
Degree of Operating Leverage
• Substituting the two sales figures ($5
million and $5.5 million) and associated
EBIT figures ($1 million and $1.2 million)
into equation yields the following:
$1, 200, 000  $1, 000, 000
$1, 000, 000
DOL at $5,000,000 
$5,500, 000  $5, 000, 000
$5, 000, 000
 2.0
Degree of Operating Leverage
• A DOL of 2.0 is interpreted to mean that
each 1 percent change in sales from a
base sales level of $5 million results in a
2 percent change in EBIT in the same
direction as the sales change. In other
words, a sales increase of 10 percent
results in a 20% increase in EBIT.
Similarly, a 10 percent decrease in sales
produces a 20% decrease in EBIT.
Degree of Operating Leverage
• The greater a firm’s DOL, the greater the
magnification of sales changes into EBIT
changes.
Degree of Operating Leverage
• Another equation that can be used to
compute a firm’s DOL more easily is
Equation (13.2) as follows:
Sales  Variable costs
DOL at X 
EBIT
• Note:
EBIT = Sales – Variable costs – Fixed costs
Degree of Operating Leverage
• Inserting data from Table 13.1 on the
Allegan Manufacturing Company into
Equation (13.2) gives the following:
$5 million  $3 million
DOL at $5 million 
$1 million
 2.0
This result is the same as that obtained
using the more complex Equation (13.1).
Degree of Operating Leverage
TABLE 13.3 DOL at Various Sales Levels, Allegan Manufacturing Company
Sales, TR (Total Revenue) = P*Q
Degree of Operating Leverage, DOL
$500,000
-0.25
1,000,000
-0.67
1,500,000
-1.50
2,000,000
-4.00
2,500,000 (Breakeven sales level)
(Undefined)
3,000,000
+6.00
3,500,000
+3.50
4,000,000
+2.67
4,500,000
+2.25
5,000,000
+2.00
5,500,000
+1.83
6,000,000
+1.71
Degree of Operating Leverage
• Table 13.3 shows the DOL at various
sales levels for Allegan Mangan
Manufacturing Company. Note that
Allegan’s DOL is largest (in absolute
value terms) when the firm is operating
at the break-even sales point [that is,
where Sales = $2,500,000 and EBIT =
Sales – Variable Operating Costs –
Fixed Operating Costs = $2,500,000 –
0.6($2,500,000) – $1,000,000 = $0].
Degree of Operating Leverage
• Note also that the firm’s DOL is negative
below the break-even sales level. A
negative DOL indicates the percentage
reduction in operating losses that occurs
at the result of a 1 percent increase in
output. For example, the DOL of -1.50 at
a sales level of $1,500,000 indicates
that, from a base sales level of
$1,500,000, the firm’s operating losses
are reduced by 1.5 percent for each 1
percent increase in output.
Degree of Operating Leverage
• A firm’s DOL is a function of the nature
of the production process. If the firm
employs large amounts of labor-saving
equipment in its operations, it tends to
have relatively high fixed operating costs
and relatively low variable operating
costs. Such a cost structure yields a high
DOL, which results in large operating
profits (positive EBIT) if sales are high
and large operating losses (negative
EBIT) if sales are depressed.
Degree of Financial Leverage
• A firm’s degree of financial leverage
(DFL) is computed as the percentage
change in earnings per share (EPS)
resulting from a given percentage
change in earnings before interest and
taxes (EBIT):
Percentage change in EPS
DFL at X 
Percentage change in EBIT
Degree of Financial Leverage
• The formula in the previous slide can
also be written as Equation (13.3) as
follows:
EPS
DFL at X  EPS
EBIT
EBIT
where ΔEPS and ΔEBIT are the changes
in EPS and EBIT, respectively.
Degree of Financial Leverage
• Because a firm’s DFL is different at each
EBIT level, it is necessary to indicate the
EBIT point, X, at which financial leverage
is being measured.
Degree of Financial Leverage
TABLE 13.4 Earnings per Share for Alternative Levels of EBIT, Allegan
Manufacturing Company, Year Ending December 31, 20X1
EBIT
$400,000 $800,000 $1,000,000 $1,200,000 $1,600,000
Less Interest
250,000 250,000
250,000
250,000
250,000
expenses
Earnings before taxes $150,000 $550,000
$750,000
$950,000 $1,350,000
Less Income taxes
60,000 220,000
300,000
380,000
540,000
Earnings after taxes
$90,0000 $330,000
$450,000
$570,000
$810,000
Less Preferred
150,000 150,000
150,000
150,000
150,000
dividend
Earnings available to
$-60,000 $180,000
$300,000
$420,000
$660,000
common stockholders
Earnings per share
$-0.60
$1.80
$3.00
$4.20
$6.60
(EPS)
Degree of Financial Leverage
• Using the information contained in Table
13.4 and shown in Figure 13.2, the
degree of financial leverage used by the
Allegan Manufacturing Company can be
calculated. The firm’s EPS level is $3.00
at an EBIT level of $1 million. At an EBIT
level of $1.2 million, EPS equals $4.20.
Substituting these quantities into the
Equation yields the following:
Degree of Financial Leverage
($4.20  $3.00)
$3.00
DFL at $1,000,000 
($1, 200, 000  $1, 000, 000)
$1, 000, 000
 2.0
A DFL of 2.0 indicates that each 1
percent change in EBIT from a base
EBIT level of $1 million results in a 2
percent change in EPS in the same
direction as the EBIT change.
Degree of Financial Leverage
• The formula of DFL can also be rewritten
as follows (13.4):
DFL at X 
EBIT
Dp
EBIT  I 
1 T
where I is the firm’s interest payments,
Dp the firm’s preferred dividend
payments, T the firm’s marginal income
tax rate, and X the level of EBIT at which
the firm’s DFL is being measured.
Degree of Financial Leverage
• For the firm with no preferred stock,
Equation (13.4) becomes the following:
EBIT
EBIT
DFL at X 

EBIT  I
EBT
where EBT represents earnings before
taxes.
Degree of Financial Leverage
• Unlike interest payments, preferred
dividend payments are not tax
deductible. Therefore, on a comparable
tax basis, a dollar of preferred dividends
costs the firm more than a dollar of
interest payments. Dividing preferred
dividends in Equation (13.4) by (1 – T)
puts interest and preferred dividends on
an equivalent, pretax basis.
Degree of Financial Leverage
• As shown in Figure 13.2, Allegan will
have EPS = $0 at an EBIT level of
$500,000. With this level of EBIT, there
is just enough operating earnings to pay
interest ($250,000) and preferred
dividends (after-tax). Using the Equation
(13.4), it can be seen that DFL will be
maximized at that level of EBIT where
EPS = 0.
Degree of Financial Leverage
• Consider again the data presented in
Table 13.1 on the Allegan Manufacturing
Company. According to that table, EBIT
= $1 million, I = $250,000, Dp =
$150,000, and T = 40 percent, or 0.40.
Degree of Financial Leverage
• Substituting these values into the
Equation (13.4) yields the following:
DFL at $1,000,000 
$1,000,000
$150,000
$1,000,000  $250,000 
1  0.40
 2.0
This result is the same as that obtained
using Equation (13.3).
Degree of Financial Leverage
• Just as a firm can change its DOL by
raising or lowering fixed operating costs,
it can also change its DFL by increasing
or decreasing fixed capital costs. The
amount of fixed capital costs incurred by
a firm depends primarily on the mix of
debt, preferred stock, and common stock
equity in the firm’s capital structure.
Degree of Financial Leverage
• Thus, a firm that has a relatively large
proportion of debt and preferred stock in
its capital structure will have relatively
large fixed capital costs and a high DFL.
Degree of Combined Leverage
• Combined leverage occurs whenever a
firm employs both operating leverage
and financial leverage in an effort to
increase the returns to common
stockholders.
Degree of Combined Leverage
• Combined leverage represents the
magnification of sales increases (or
decreases) into relatively larger earnings
per share increases (or decreases),
resulting from the firm’s use of both
types of leverage. The joint multiplier
effect is known as the degree of
combined leverage.
Degree of Combined Leverage
• A firm’s degree of combined leverage
(DCL) is computed as the percentage
change in earnings per share resulting
from a given percentage change in
sales:
Percentage change in EPS
DCL at X 
Percentage change in sales
Degree of Combined Leverage
• The formula in the previous slide can be
rewritten as Equation (13.5) as follows:
EPS
DCL at X  EPS
Sales
Sales
where ΔEPS and ΔSales are the
changes in a firm’s EPS and sales,
respectively, and X represents the level
of sales at which the firm’s combined
leverage is measured.
Degree of Combined Leverage
• The degree of combined leverage is also
equal to the product of the degree of
operating leverage and the degree of
financial leverage.
DCL at X = DOL*DFL
(13.6)
Degree of Combined Leverage
• To simplify matters, Equations (13.2) and
(13.4) can be substituted into Equation
(13.6) to obtain a new formula for
determining the DCL in terms of basic
income statement quantities:
Sales  Variable costs
EBIT
DCL at X 

EBIT
EBIT  I  Dp /(1  T
or
Sales  Variable costs
DCL at X 
EBIT  I  Dp /(1  T )
Degree of Combined Leverage
• These three formulas for calculating DCL
can be illustrated using the Allegan
Manufacturing Company example.
Equation (13.5) can be used to calculate
Allegan’s DCL with the data from Tables
13.1 and 13.2.
Degree of Combined Leverage
• The EPS level was $3.00 at a sales level
of $5 million and $4.20 at a sales level of
$5.5 million. Substituting these values
into Equation (13.5) yields the following:
($4.20  $3.00)
$3.00
DCL at $5,000,000 
($5,500, 000  $5, 000, 000)
$5, 000, 000
 4.0
Degree of Combined Leverage
• Substituting Sales = $5,000,000;
Variable costs = $3,000,000; EBIT =
$1,000,000; I = $250,000; Dp =
$150,000; and T = 40% into Equation
(13.7) gives the same value for Allegan’s
DCL:
DCL at $5,000,000
$5, 000, 000  $3, 000, 000

 4.0
$150, 000
$1, 000, 000  $250, 000 
(1  0.40)
Degree of Combined Leverage
• Also, recall from the earlier discussion of
operating and financial leverage for
Allegan that DOL = 2.0 and DFL = 2.0.
Substituting these values into Equation
(13.6) yields a DCL value identical to
that just calculated:
DCL at $5,000,000 = 2.0*2.0 = 4.0
Degree of Combined Leverage
• This DCL is interpreted to mean that
each 1 percent change in sales from a
base sales level of $5 million results in a
4 percent change in Allegan’s EPS.
Degree of Combined Leverage
• The degree of combined leverage used
by a firm is a measure of the overall
variability of EPS due to fixed operating
and capital costs as sales levels vary.
Fixed operating and capital costs can be
combined in many ways to achieve a
desire DCL. In other words, a number of
possible trade-offs can be made
between operating and financial
leverage.
Degree of Combined Leverage
• Equation (13.6) shows that DCL is a
function of DOL and DFL. If a firm has
relatively high DOL, for example, and
wishes to achieve a certain DCL, it can
offset this high DOL with a lower DFL. Or
it may have a high DFL, in which case it
would aim for a lower DOL.
Degree of Combined Leverage
• To illustrate, assume that a firm is
considering purchasing assets that will
increase fixed operating costs. To offset
this high DOL, the firm may want to
decrease the proportion of debt in its
capital structure, thereby reducing fixed
financial costs and the DFL.
Effect of Leverage on Shareholder
Wealth and the Cost of Capital
• Firms are limited in the amount of
combined (i.e., operating and financial)
leverage that can be used in seeking to
increase EPS and shareholder wealth.
Recall from Chapter 12 (see Figures
12.4, 12.5, and 12.6) that the use of
“excessive” amounts of financial
leverage caused the market value of the
firm (i.e., shareholder wealth) to decline
and the cost of capital to rise.
Effect of Leverage on Shareholder
Wealth and the Cost of Capital
• Like financial leverage, the use of
increasing amounts of combined
leverage increases the risk of financial
distress. As this risk increases, investors
will require higher rates of return on the
funds supplied to the firm in the form of
preferred and common equity and debt.
Effect of Leverage on Shareholder
Wealth and the Cost of Capital
• In other words, because of the financial
distress costs and agency costs
associated with “excessive” combined
leverage, the firm will have to pay higher
costs for its funds. These higher costs
will tend to offset the returns gained from
the combined leverage, resulting in a
decline in the market value of the firm
and a rise in its cost of capital.
How Can You Find the Probability
of EPS?
• Probability of negative EPS
Loss level EBIT  Expected EBIT
Z
Standard deviation of EBIT
– Loss level of EBIT is the amount of EBIT
needed to cover interest charged and
preferred dividends.
– The Z value can be looked up in Table V
(Normal Distribution).
How Can You Find the Probability
of EPS?
• It is possible to make more formal
statements about the financial risk facing
a company if the probability distribution
of future operating income (EBIT) is
approximately normal and the mean and
standard deviation can be estimated.
How Can You Find the Probability
of EPS?
• The number of standard deviation, z, that
a particular value of EBIT is from the
expected value, EBIT^, can be
computed as Equation (13.8) as follows:
EBIT  EBIT^
z
σ
where  is the standard deviation of
EBIT.
How Can You Find the Probability
of EPS?
• Equation (13.8), along with the
probability values from Table V in the
back of the book, can be used to
compute the probability that EBIT will be
less than (or greater than) some
particular value.
How Can You Find the Probability
of EPS?
• For example, consider the case of the
Travco Manufacturing Corporation.
Given the current capital structure of
Travco, the company has interest
payment obligations of $500,000 for the
coming year. The company has no
preferred stock. The $500,000 in interest
represents the loss level for Travco.
How Can You Find the Probability
of EPS?
• If EBIT falls below $500,000, losses will
be incurred (EPS will be negative). At
EBIT levels above $500,000, Travco will
have positive earnings per share.
How Can You Find the Probability
of EPS?
• Based upon past experience, Travco’s
managers have estimated that the
expected value of EBIT over the coming
year is $700,000 with a standard
deviation of $200,000 and that the
distribution of operating income is
approximately normal, as illustrated in
Figure 13.3.
How Can You Find the Probability
of EPS?
• With this information, it is possible to
compute the probability of Travco having
negative earnings per share over the
coming year (or, conversely, the
probability of having positive earnings
per share).
How Can You Find the Probability
of EPS?
• Using Equation (13.8), the probability of
Travco having negative EPS is equal to
the probability of having EBIT below the
loss of $500,000, or
$500, 000  $700, 000
z
 1.0
$200, 000
In other words, a level of EBIT of
$500,000 is 1.0 standard deviation below
the mean.
How Can You Find the Probability
of EPS?
• From Table V, it can be seen that the
probability associated with a value that is
less than or equal to 1.0 standard
deviation below the mean is 15.87
percent. Thus, there is a 15.87 percent
chance that Travco will have negative
earnings per share (i.e., the shaded area
in Figure 13.3) with its current capital
structure. Conversely, there is an 84.13
percent chance (=100% – 15.87%) of
having positive earnings per share.
EBIT-EPS Analysis
• An analytical technique called EBIT-EPS
analysis can be used to help determine
when debt financing is advantageous
and when equity financial is
advantageous.
EBIT-EPS Analysis
• Consider the Yuma Corporation with a
present capital structure consisting only
of common stock (35 million shares).
– Plan 1, equity financing, would involve the
sale of an additional 15 million shares of
common stock at $20 each.
– Plan 2, debt financing, would involve the
sale of $300 million of 10 percent long-term
debt.
EBIT-EPS Analysis
• If the firm adopts Plan 1, it remains
totally equity financial. If, however, the
firm adopts Plan 2, it becomes partially
debt financed. Because Plan 2 involves
the use of financial leverage, this
financing issue is basically one of
whether it is in the best interests of the
firm’s existing stockholders to employ
financial leverage.
EBIT-EPS Analysis
TABLE 13.5 EBIT-EPS Analysis, Yuma Corporation (All Dollar Figures
Except Per-Share Amounts Are in Millions of Dollars)
EBIT = $75
EBIT = $12
Equity Financing (Plan 1)
Earnings before interest and taxes
$ 75
$12
Interest
Earnings before taxes
$75
$12
Taxes @ 40%
30
5
Earnings after taxes
$45
$7
Shares outstanding
50
5
Earnings per share
$0.90
$1.5
% change in EBIT
+66.67%
% change in EPS
+66.67%
Degree of financial leverage
1.0
EBIT-EPS Analysis
TABLE 13.5 EBIT-EPS Analysis, Yuma Corporation (All Dollar Figures
Except Per-Share Amounts Are in Millions of Dollars)
EBIT = $75
EBIT = $12
Debt Financing (Plan 2)
Earnings before interest and taxes
$75
$12
Interest
30
3
Earnings before taxes
$45
$9
Taxes @ 40%
18
3
Earnings after taxes
$27
$5
Shares outstanding
35
3
Earnings per share
$0.77
$1.6
% change in EBIT
+66.67%
% change in EPS
+111.69%
Degree of financial leverage
1.6
EBIT-EPS Analysis
• Table 13.5 illustrates the calculation of
EPS at two different assumed levels of
EBIT for both financing plans. Because
the relationship between EBIT and EPS
is linear, the two points calculated in
Table 13.5 can be used to graph the
relationship for each financing plan, as
shown in Figure 13.4.
EBIT-EPS Analysis
• In this example, earnings per share at
EBIT levels less than $100 million are
higher using the equity financing
alternative. Correspondingly, at EBIT
levels greater than $100 million,
earnings per share are higher with debt
financing. The $100 million figure is
called the EBIT-EPS indifference point.
EBIT-EPS Analysis
• By definition, the earnings per share for
the debt and equity financing alternatives
are equal at the EBIT-EPS indifference
point (13.9):
EPS (debt financing)
= EPS (equity financing)
EBIT-EPS Analysis
• This equation may be written as
Equation (13.10) as follows:
(EBIT  I d )(1  T )  Dp
Nd

(EBIT  I e )(1  T )  Dp
Ne
where EBIT is earnings before interest and taxes;
Id (Ie) is the firm’s total interest payments if the
debt (equity) alternative is chosen; and Nd (Ne)
represents the number of common shares
outstanding for the debt (equity) alternatives. The
firm’s effective tax rate is indicated as T, and Dp is
the amount of preferred dividends for the firm.
EBIT-EPS Analysis
• This equation may be used to calculate
directly the EBIT level at which earnings
per share for the two alternatives are
equal. The data from the example shown
in Table 13.5 yield the EBIT-EPS
indifference point:
(EBIT  $30)(1  0.4)  0 (EBIT  $0)(1  0.4)  0

35
50
 EBIT  $100 (million)
EBIT-EPS Analysis
• Note that in the equity financing
alternative, a 66.67 percent increase in
EBIT (from $75 million to $125 million)
results in a 66.67 percent increase in
earnings per share (from $0.90 to
$1.50), or, by Equation (13.3), a degree
of financial leverage of
DFL = 66.67%  66.67% = 1
EBIT-EPS Analysis
• Similarly, in the debt financing
alternative, a 66.67 percent increase in
EBIT (from $75 million to $125 million)
results in a 111.69 percent increase in
earnings per share (from $0.77 to
$1.63), or a degree of financial leverage
of
DFL = 111.69%  66.67% = 1.68
EBIT-EPS Analysis
• A comparable magnification of earnings
per share will occur if EBIT declines.
This wider variation in earnings per
share, which occurs with the debt
financing alternative, is an illustration of
financial risk, because financial risk is
defined as the increased variability in
earnings per share due to the firm’s use
of debt.
EBIT-EPS Analysis
• All other thing being equal, an increase
in the proportion of debt financing is said
to increase the financial risk of the firm.
Graphical Analysis of EBIT - EPS
EPS
Debt Financing
Advantage to
equity financing
Equity Financing
Advantage to debt
financing
Indifference Point
EBIT
EBIT-EPS Analysis and Capital
Structure Decisions
• The tools of EBIT-EPS analysis and the
theory of an optimal capital structure can
help a firm choose an appropriate capital
structure.
• This section uses an example to develop
a five-step procedure designed to assist
financial managers in making capital
structure decisions.
EBIT-EPS Analysis and Capital
Structure Decisions
• Balboa Department Stores has been 100
percent financial with equity funds since
the firm was founded. While analyzing a
major expansion program, the firm has
decided to consider alternative capital
structures.
EBIT-EPS Analysis and Capital
Structure Decisions
• In particular, it has been suggested that
the firm should use this expansion
program as an opportunity to increase
the long-term debt ratio from the current
level of 0 percent to a new level of 30
percent. Interest on the proposed new
debt will amount to $100,000 per year.
EBIT-EPS Analysis and Capital
Structure Decisions
• Step 1: Compute the expected level of
EBIT after the expansion.
– Based on Balboa’s past operating
experience and a projection of the
impact of the expansion, it estimates
its expected EBIT to be $500,000 per
year under normal operating
circumstances.
EBIT-EPS Analysis and Capital
Structure Decisions
• Step 2: Estimate the variability of this
level of operating earnings.
– Based on the past performance of the
company over several business
cycles, the standard deviation of
operating earnings is estimated to be
$200,000 per year. (Operating
earnings are assumed to be normally
distributed, or at least approximately
so.)
EBIT-EPS Analysis and Capital
Structure Decisions
• Step 3: Compute the indifference
point between the two financing
alternative.
– This calculation will determine whether
it is preferable to add new debt or to
maintain the all-equity capital
structure. Using the techniques of
EBIT-EPS analysis previously
discussed, the indifference point is
computed to be $300,000.
EBIT-EPS Analysis and Capital
Structure Decisions
• Step 4: Analyze these estimates in the
context of the risk the firm is willing
to assume.
– After considerable discussion, it has
been decided that the firm is willing to
accept a 25 percent chance that
operating earnings in any year will be
below the indifference point and a 5
percent chance that the firm will have
to report a loss in any year.
EBIT-EPS Analysis and Capital
Structure Decisions
• To compute this analysis, it is necessary
to compute the probability that operating
earnings will be below the indifference
point, that is, the probability that EBIT
will be less than $300,000.
EBIT-EPS Analysis and Capital
Structure Decisions
• This is equivalent on the standard
normal curve (using Equation (13.8)) to
the following:
$300, 000  $500, 000
z
 1.0
$200, 000
or 1.0 standard deviation below the
mean.
EBIT-EPS Analysis and Capital
Structure Decisions
• The probability that EBIT will be less
than 1.0 standard deviation below the
mean is 15.87 percent; this is
determined from Table V. Therefore, on
the basis of the indifference point
criterion, the proposed new capital
structure appears acceptable.
EBIT-EPS Analysis and Capital
Structure Decisions
• The probability of incurring losses must
now be analyzed. This is the probability
that EBIT will be less than the required
interest payments of $100,000. On the
standard normal curve, this corresponds
to the following:
$100, 000  $500, 000
z
 2.0
$200, 000
or 2.0 standard deviations below the
mean.
EBIT-EPS Analysis and Capital
Structure Decisions
• The probability that EBIT will be less
than 2.0 standard deviations below the
mean is 2.28 percent, as shown in Table
V. According to this criterion, the
proposed capital structure also seems
acceptable.
EBIT-EPS Analysis and Capital
Structure Decisions
• If either or both of these tests had shown
the proposed capital structure to have an
unacceptable level of risk, the analysis
would have been repeated for lower
levels of debt than the proposed 30
percent rate.
EBIT-EPS Analysis and Capital
Structure Decisions
• Similarly, because the proposed capital
structure has exceeded the standards
set by the firm, management might want
to consider even higher levels of debt
than the proposed 30 percent.
EBIT-EPS Analysis and Capital
Structure Decisions
• Step 5: Examine the market evidence
to determine whether the proposed
capital structure is too risky.
– This evaluation should be made in
relation to the following: the firm’s level
of business risk, industry norms for
leverage ratios and coverage ratios,
and the recommendations of the firm’s
investment bankers.
EBIT-EPS Analysis and Capital
Structure Decisions
– This step is undertaken only after a
proposed capital structure has met the
“internal” tests for acceptability.
EBIT-EPS Analysis and Capital
Structure Decisions
• Financial leverage is a double-edged
sword: it enhances expected returns, but
it also increases risk. If the increase in
perceived risk is greater than the
increase in expected returns, the firm’s
weighted average costs of capital may
rise instead of fall, and the firm’ stock
price and market value will decline.
EBIT-EPS Analysis and Capital
Structure Decisions
• It is important to note that a firm need
not feel constrained by industry
standards in setting its own capital
structure. If, for example, a firm has
traditionally been more profitable than
the average firm in the industry, or if a
firm’s operating income is more stable
than the operating income of the
average firm, a higher level of financial
leverage can probably be tolerated.
EBIT-EPS Analysis and Capital
Structure Decisions
• The final choice of a capital structure
involves a careful analysis of expected
future returns and risks relative to other
firms in the industry.
EBIT-EPS Analysis and Stock
Prices
• An important question arising from EBITEPS analysis is the impact of financial
leverage on the firm’s common stock
price. Specifically, which alternative
results in the higher stock price?
EBIT-EPS Analysis and Stock
Prices
• Returning to the Yuma Corporation
example discussed earlier (see Table
13.5), suppose the company is able to
operate at the $125 million EBIT level.
Then, if the company chooses the debt
financing alternative, its EPS will equal
$1.63, and if it chooses the equity
alternative, its EPS will be $1.50. But the
stock price depends on the priceearnings (P/E) ratio that the stock market
assigns to each alternative.
EBIT-EPS Analysis and Stock
Prices
• Suppose the stock market assigns a P/E
ratio of 16.0 to the company’s common
stock if the equity alternative is chosen
and a P/E ratio of 15.4 if the debt
alternative is chosen.
EBIT-EPS Analysis and Stock
Prices
• Recalling from Chapter 3 that the P/E
ratio was defined as the market price per
share of common stock (P0) divided by
the current earnings per share (EPS),
the common stock price can be
calculated for both alternatives as
follows: P0 = (P/E ratio)(EPS)
– Equity alternative:
P0 = (16.0)($1.50) = $24.00
– Debt alternative:
EBIT-EPS Analysis and Stock
Prices
• These calculations show that in this case
the stock market places a higher value
on the company’s stock if the debt
alternative is chosen rather than the
equity alternative.
EBIT-EPS Analysis and Stock
Prices
• Note that the stock market assigned a
slightly lower P/E ratio to the debt
alternative. The stock market recognized
the increased financial risk associated
with the debt alternative, but this
increased risk was more than offset by
the increased EPS possible with the use
of debt.
EBIT-EPS Analysis and Stock
Prices
• To carry the Yuma Corporation example
one important step further, suppose the
company, while operating at the $125
million EBIT level, chooses an even
higher debt capital structure, which
causes its EPS to increase to $2.25.
EBIT-EPS Analysis and Stock
Prices
• Suppose further that the stock market
feels that this high-debt capital structure
significantly increases the company’s
financial risk—to the point where
bankruptcy could occur if EBIT levels
turned downward in a recession. If the
stock market assigns a P/E ratio of 10.0,
for example, the stock price would be
$22.50 (= $2.25*10.0), and it would be
clear that this change in capital structure
is not desirable.
EBIT-EPS Analysis and Stock
Prices
• It is important to emphasize that the P/E
ratios in the preceding example are
simply assumptions. As an analytical
technique, EBIT-EPS analysis does not
provide a complete solution to the
optimal capital structure question.
EBIT-EPS Analysis and Stock
Prices
• In summary, the firm potentially can
show increased earnings to its
stockholders by increasing its level of
financial risk. However, because
increases in risk tend to increase the
cost of capital (which is analogous to a
decrease in the P/E ratio), the firm’s
management has to assess the trade-off
between the higher earnings per share
for its stockholders and the higher costs
of capital.
Cash Insolvency Analysis
• In Chapter 3, the times interest earned
and fixed-charge coverage ratios were
introduced. These ratios provide an
indicator of the ability of a firm to meet its
interest and other fixed charge
obligations (including lease payments,
sinking fund payments, and preferred
dividends) out of current operating
income.
Cash Insolvency Analysis
• Also, in that chapter, liquidity ratios such
as the current ratio and the quick ratio,
were introduced. Liquidity ratios provide
a simple measure of a firm’s ability to
meet its obligations, especially in the
near term. In that chapter, we also
indicated that the best measure of a
firm’s cash adequacy can be obtained by
preparing a detailed cash budget, which
is discussed in greater detail in Chapter
15.
Cash Insolvency Analysis
• Coverage ratios and liquidity ratios do
not provide an adequate picture of a
firm’s solvency position. A firm is said to
be technically insolvent if it is unable to
meet its current obligations. A more
comprehensive measure of the ability of
a firm to meet its obligations must
consider both the cash on hand and the
cash expected to be generated in the
future.
Cash Insolvency Analysis
• Donaldson has suggested that a firm’s
level of fixed financial charges (including
interest, preferred dividends, sinking
fund obligations, and lease payments),
and thus its debt-carrying capacity,
should depend on the cash balances
and net cash flows that can be expected
to be available in a worst-case
(recessionary environment) scenario.
This analysis requires the preparation of
a detailed cash budget under assumed
recessionary conditions.
Cash Insolvency Analysis
• Donaldson defines a firm’s net cash
balance in a recession, CBR, to be
Equation (13.12) as follows:
CBR = CB0 + FCFR
where CB0 is the cash (and marketable
securities) balance at the beginning of
the recession, and FCFR is the free cash
flows expected to be generated during
the recession.
Cash Insolvency Analysis
• Free cash flow represents the portion of
a firm’s total cash flow available to
service additional debt, to make dividend
payments to common stockholders, and
to invest in other projects.
Cash Insolvency Analysis
• For example, suppose MINECO, a
natural resource company, reported a
cash (and marketable securities)
balance of approximately $154 million.
Suppose also that management
anticipates free cash flows of $210
million during a projected one-year
recession. These free cash flows reflect
both operating cash flows during the
recession and current required fixed
financial charges.
Cash Insolvency Analysis
Under the current capital structure,
consisting of approximately 32 percent
debt, the cash balance at the end of the
recession would be $364 million ($154
million plus $210 million). Assume that
the management of MINECO is
considering a change in its capital
structure that would add an additional
$280 million of annual after-tax interest
and sinking fund payments (i.e., fixed
financial charges).
Cash Insolvency Analysis
The effect would be a cash balance at
the end of the recession of
CBR = $154 million + $210 million
– $280 million
= $84 million
The managers of MINECO must decide
if this projected cash balance of $84
million leaves them enough of a cushion
in a recession.
Cash Insolvency Analysis
• This analysis can be enhanced if it is
possible to specify the probability
distribution of expected free cash flows
during a recession.
Cash Insolvency Analysis
• For example, if the MINECO managers
believe, based upon past experience,
that free cash flows are approximately
normally distributed [see panel (a) of
Figure 13.5] with an expected value
during a one-year recession (FCFR) of
$210 million and a standard deviation of
$140 million, they can compute the
probability of running out of cash if the
new debt is added.
Cash Insolvency Analysis
The probability of running out of cash is
equal to the probability of ending the
recession with a cash balance of less
than $0.
Cash Insolvency Analysis
The probability distribution of MINECO’s
cash balance [panel (b) of Figure 13.5]
will have the same shape (i.e.,
approximately normal with a standard
deviation, σ, of $140 million) as the
probability distribution of free cash flows
[panel (a) of Figure 13.5], except that it
will be shifted to the left from a mean
(FCFR) of $210 million to a mean (CBR)
of $84 million (= $154 million + $210
million – $280 million).
Cash Insolvency Analysis
Employing an expression similar to
Equation (13.8), a cash balance of $0 is
equivalent on the standard normal curve
to the following:
($0  $84 million)
z
 0.60
$140 million
Cash Insolvency Analysis
From Table V, the probability of a z value
of -0.60 or less is 27.43 percent. Thus,
with an additional $280 million in fixed
financial charges, the probability of
MINECO running out of cash during a
one-year recession is about 27 percent
[i.e., shaded area in panel (b) of Figure
13.5].
Cash Insolvency Analysis
• The MINECO managers may feel that
this is too much risk to assume. If they
only want to assume a 5 percent risk of
running out of cash during a one-year
recession, they can determine the
amount of additional interest and sinking
fund payments (i.e., fixed financial
charges) that can be safely added.
Cash Insolvency Analysis
First, find the number of standard
deviation (z) to the left of the mean that
gives a 5 percent probability of
occurrence in the lower tail of the
distribution (i.e., the shaded area in
Figure 13.6). From Table V, this value of
z is found to be approximately -1.65.
Cash Insolvency Analysis
Next, we calculate the expected cash
balance (CBR) needed at the end of a
one-year recession if the risk of running
out of cash is to be held to 5 percent:
($0  $CBR )
z  1.65 
$140 million
 CBR  $231 million
Cash Insolvency Analysis
Finally, since MINECO expects to enter
the recession with $154 million in cash
and to generate $210 million in free cash
flow during a one-year recession, it can
take on just $133 million (= $154 million
+ $210 million – $231 million) in
additional fixed financial charges.
Cash Insolvency Analysis
• The willingness of management to
assume the risk associated with running
out of cash depends on several factors,
including funds available from
outstanding lines of credit with banks
and the sale of new long-term debt,
preferred stock, and common stock, and
the potential funds realized by cutting
back on expenses during a business
downturn, reducing dividends, and
selling assets.
Factors Considered in Capital
Structure Decisions
• Industry Standard
– Financial analysts, investment bankers,
bond rating agencies, common stock
investors, and commercial bankers normally
compare the financial risk for a firm, as
measured by its interest and fixed-charge
coverage ratios and its long-term debt ratio,
with industry standards or norms.
Factors Considered in Capital
Structure Decisions
• Profitability and Need for Funds
– Highly profitable firms, with limited needs for
funds, tend to have lower debt ratios when
compared with less profitable firms.
– Firms that undertake highly leveraged
restructurings may temporarily have debt
ratios that are significantly above the
optimal level until funds from asset sales,
new equity issues, or operations can be
generated to pay off the debt holders.
Factors Considered in Capital
Structure Decisions
• Lender and Bond-Rater Requirements
– Lenders and bond-rating agencies often
impose restrictions on a firm’s capital
structure choices as a condition for
extending credit or maintaining a bond or
preferred stock rating.
Factors Considered in Capital
Structure Decisions
• Managerial Risk Aversion
– Management’s willingness to assume risk
often has a major impact on the capital
structure chosen by the firm, although the
relative risk aversion of management does
not influence the firm’s optimal capital
structure. Some managers adopt unusually
risky or unusually low-risk capital structures.
When a suboptimal capital structure is
chosen, the financial marketplace will
normally penalize a firm for this action.