Chapter 12 - Northern Virginia Community College,...

Chapter 12

Determining the Financing Mix

© 2017 Pearson Education, Inc. All rights reserved. 12-2

Learning Objectives

• Distinguish between business and financial risk.

• Use break-even analysis.

• Understand the relationship between operating, financial, and combined leverage.

• Discuss the concept of an optimal capital structure.

• Use the basic tools of capital structure management.


UNDERSTANDING THE DIFFERENCE BETWEEN BUSINESS AND

FINANCIAL RISK


Risk

• Risk is 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 a capital structure (financial risk)


Business Risk

• Business risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk:

– The stability of the domestic economy

– The exposure to, and stability of, foreign economies

– Sensitivity to the business cycle

– Competitive pressures in the firm’s industry


Operating Risk

• Operating risk is the variation in the firm’s operating earnings that results from firm’s 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.


Financial Risk

• Financial risk is the variation in earnings as a result of firm’s financing mix or proportion of financing that requires a fixed return.


BREAK-EVEN ANALYSIS


Break-Even Analysis

• Break-even analysis is used to determine the break-even quantity of a firm’s output by examining the relationships among the firm’s 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 earnings before interest and taxes (EBIT) is equal to zero.


Break-Even Analysis

Use of break-even model enables the financial manager to

• determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs.

• calculate the EBIT that will be achieved at various output levels.


Essential Elements of the Break-Even Model

• Break-even analysis requires information on the following:– Fixed Costs

– Variable Costs

– Total Revenue

– Total Volume


Essential Elements of the Break-Even Model

• 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 long run, break-even analysis is a short-run concept.


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.


Fixed Costs Examples

1. Administrative salaries

2. Depreciation

3. Insurance

4. Lump sums spent on intermittent advertising programs

5. Property taxes

6. Rent


Variable or Direct Costs

• Variable costs vary as output changes. Thus if production is increased by 10%, total variable costs will also increase by 10%.


Variable Costs Examples

1. Direct labor

2. Direct materials

3. Energy costs (fuel, electricity, natural gas) associated with the production

4. Freight costs

5. Packaging

6. Sales commissions


Revenue

• Total revenue is the total sales dollars.

• Total revenue = P Q

P = selling price per unit

Q = quantity sold


Volume

• The volume of output refers to the firm’s level of operations and may be indicated either as a unit quantity or as sales dollars.


Break-Even Point (BEP)

• BEP = Point at which EBIT equals zero


Example

• Selling price = $10 per unit

Variable cost = $6 per unit

Fixed costs = $100,000

• BEP (units) = $100,000/ ($10 – $6)= $100,000/$4= 25,000 units

• If the firm sells 25,000 units, EBIT will be equal to zero dollars.


Example in dollars


SOURCES OF OPERATING LEVERAGE


Operating Leverage

• Operating leverage measures the sensitivity of the firm’s 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.


Operating Leverage

•

• Thus % change in EBIT = OL % change in sales

Where : % change in EBIT = EBITt1 – EBITt / EBITt

% change in sales = Salest1 – Salest / Salest


Operating Leverage

• Example : If a company has an operating leverage (OL) of 6, then what is the change in EBIT if sales increase by 5%?

% change in EBIT = OL % change in sales= 6 5% = 30%

• Thus, if the firm increases sales by 5%, EBIT will increase by 30%


Operating Leverage

• Operating leverage is present when% change in EBIT / % change in sales is

> 1.00

• The greater the firm’s degree of operating leverage, the more the profits will vary in response to change in sales.


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 drop 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%.


Financial Leverage

• Financial leverage means financing a portion of the firm’s assets with securities bearing a fixed (limited) 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 the firm’s use of financial leverage.


Three Capital Structure Plans

• 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.


Capital Structure Plans

• A firm employing financial leverage is exposing its owners to financial risk when:

– Percentage change in EPS divided by percentage change in EBIT is greater than 1.00


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.


Combined Leverage

• Combined Leverage = Percentage Change in EPS/Percentage Change in Sales

• Or, Combined Leverage = Operating Leverage Financial Leverage

• See Table 12-6


Combining Operating and Financial Leverage

• Table 12-6 shows that a modest 20% increase in sales revenue translates to 150% increase in EPS due to the combined leverage effect.


CAPITAL STRUCTURE THEORY


Financial & Capital Structure

• Financial Structure– Mix of all items that appear on the right-hand

side of the company’s balance sheet (see Table 12-7).

• Capital Structure– Mix of the long-term sources of funds used by

the firm

– Capital Structure = Financial Structure – Non-interest- bearing liabilities (accounts payable, accrued expenses)


Designing a Capital Structure

• Designing a prudent capital structure requires answers to the following:

• Debt maturity composition: How should a firm best divide its total fund sources between short-term and long-term debt components?

• Debt-equity composition: What mix of debt and equity should the firm use?


Capital Structure Management

• A firm should mix the permanent sources of funds in a manner that will maximize the company’s stock price, or minimize the cost of capital.

• A proper mix of fund sources is called the “optimal capital structure.”


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 so as to maximize shareholder’s wealth.


Independence Position

• According to Modigliani & Miller, the total value of the firm is not 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, capital structure consisting of only stocks and bonds, perfect or efficient markets).



• Figure 12-5 shows that the firm’s value remains the same, despite the differences in financing mix.

• Figure 12-6 shows that the firm’s cost of capital remains constant, although cost of equity rises with increased leverage.



• The implication of these figures for financial managers is that one capital structure is just as good as any other.

• However, the above conclusion is possible only under strict assumptions.

• We next turn to a market and legal environment that relaxes these restrictive assumptions.


Extensions to Independence Hypothesis: The Moderate Position

• The moderate position considers how the capital structure decision is affected when we consider:– Interest expense is tax deductible (a benefit of

debt)

– Debt financing increases the risk of default (a disadvantage of debt)

• Combining the above (benefit & drawback) provides a conceptual basis for designing a prudent capital structure.


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



• Since interest on debt is tax deductible, the higher the interest expense, the lower the taxes.

• Thus, one could 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?



• One possible explanation is:

Bankruptcy costs


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) increase 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.


Impact of Bankruptcy on Capital Structure

• So, higher debt does not always lead to a higher value … after a point, debt reduces the value of the firm to shareholders.

• This explains a firm’s tendency to restrain itself 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).


Firm Value and Agency Costs

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.

To ensure that agent-managers act in shareholders best interest, firms must:


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, which 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.



• 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 type of project that management can undertake, collateral, distribution of dividends, limits on further borrowing).

• Agency costs depend on the level of debt. At lower levels of debt, creditors may not insist on a long list of bond covenants to monitor. Thus, agency cost and cost of financing are reduced at lower levels of debt.



• 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).


Managerial Implications

• Determining the firm’s financing mix is critically important for the manager.

• We observe that the decision to maximize the market value of leveraged firm is influenced primarily by the present value of tax shield benefits, present value of bankruptcy costs, and present value of agency costs.


THE BASIC TOOLS OF CAPITAL STRUCTURE

MANAGEMENT


The Basic Tools of Capital Structure Management

• Two basic tools used to evaluate capital structure decisions are:

– EBIT-EPS analysis

– Financial leverage ratios


EBIT-EPS Analysis

• Managers care about EPS, as it sends an important signal to the market about future prospects and will affect the stock prices.

• The EBIT-EPS chart provides a way to visualize the effects of alternative capital structure on both the level and volatility of the firm’s earning per share (EPS).


EBIT-EPS Chart

• 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


Finding the Intersection or EBIT-EPS Indifference Point

• Compare EPS-stock plan versus EPS-bond plan and solve for EBIT in the following two equations:

Ss = # of common shares

I = interest expenseP = preferred dividends

T = tax rate


Finding the Intersection or EBIT-EPS Indifference Point

• 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.


Comparative Leverage Ratios

• Two types of ratios (as covered in Chapter 4), balance sheet leverage ratios and coverage ratios, can be computed and compared to industry norms.

• If the ratios are significantly different from industry average, the managers must analyze further.


Financial Analysis

• To assess a firm’s financial leverage, analysts will generally use the net debt ratio

• Companies who are able to pay some or all of their debt with excess cash have less risk exposure


Capital Structure Determinants (Survey Results)

A survey of 392 corporate executives revealed the following ten factors as important determinants of capital structure decision:

Financial flexibility:Firm’s bargaining position is stronger 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.


Capital Structure Determinants (Survey Results) (cont.)

Insufficient internal funds:Firms follow a pecking order for raising funds –internal funds followed by debt and then equity.

Level of interest rates:Firms tend to borrow when interest rates are low relative to their expectations.

Interest tax savings:Debt is cheaper due to the tax benefit on interest paid. Dividend distribution does not receive any tax benefit.



Transaction costs and fees:Cost of issuing equity is relatively higher than debt, making equity a less attractive source.

Equity valuation:If shares are undervalued, firms will like to issue debt, and vice versa. Thus, valuation impacts the timing of security issue.

Comparable firm debt levels:Firms from similar businesses tend to have similar capital structures.



Bankruptcy/distress costs:

Higher level of existing debt will increase the likelihood of financial distress.

Customer/supplier discomfort:

High levels of debt will increase discomfort among customer (fearing disruption in supply) and suppliers (fearing disruption in demand and late/non- payment on existing contracts).


Key Terms

• Balance sheet leverage ratios

• Break-even quantity

• Business risk

• Capital structure

• Combined or total leverage

• Coverage ratios

• Debt capacity

• Debt-equity composition

• Debt maturity composition

• Direct costs

• EBIT-EPS indifference point

• Financial leverage

• Financial risk

• Financial structure

• Fixed or indirect costs

• Net debt

• Operating risk

• Operating leverage

• Optimal capital structure

• Optimal range of financial leverage

• Tax shield

• Total revenue

• Variable or direct costs

• Volume of output

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