LEVERAGE AND CAPITAL STRUCTURE. Business Risk and Financial Risk Risk – the likely variability...

LEVERAGE AND LEVERAGE AND CAPITAL STRUCTURECAPITAL STRUCTURE

Business Risk and Financial RiskBusiness Risk and Financial Risk

► RiskRisk – the likely variability associated with expected – the likely variability associated with expected revenue streams. revenue streams.

► The variations in the income stream can be attributed The variations in the income stream can be attributed to:to:

a.a. The firm’s exposure to business riskThe firm’s exposure to business riskb.b. The firm’s decision to incur financial riskThe firm’s decision to incur financial risk

► Business RiskBusiness Risk – the risk that comes from the nature – the risk that comes from the nature of the firm’s operating activities.of the firm’s operating activities.

► Financial RiskFinancial Risk – the risk that comes from the – the risk that comes from the financial policy (i.e capital structure) of the firm. financial policy (i.e capital structure) of the firm.

Financial and Operating LeverageFinancial and Operating Leverage

►Financial LeverageFinancial Leverage – – the extent to which a firm the extent to which a firm relies on debt. relies on debt. The more debt financing a firm The more debt financing a firm uses in its capital structure, the more financial uses in its capital structure, the more financial leverage it employs.leverage it employs.

►Operating LeverageOperating Leverage – the incurrence of fixed – the incurrence of fixed operating costs in the firm’s income stream. operating costs in the firm’s income stream.

Break-even AnalysisBreak-even Analysis► ObjectiveObjective – to determine the break-even quantity of output by – to determine the break-even quantity of output by

studying the relationships among the firm’s cost structure, studying the relationships among the firm’s cost structure, volume of output, and operating profit. volume of output, and operating profit. ► The break-even quantity of output results in an EBIT The break-even quantity of output results in an EBIT

level = 0level = 0► Some actual and potential applications of BEP include:Some actual and potential applications of BEP include:

a.a. Capital expenditure analysis as a complementary Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models.technique to discounted cash flow evaluation models.

b.b. Pricing policyPricing policyc.c. Labor contract negotiationsLabor contract negotiationsd.d. Evaluation of cost structureEvaluation of cost structuree.e. Financial decision makingFinancial decision making

Break-even AnalysisBreak-even Analysis► Essential elements of the break-even model:Essential elements of the break-even model:1.1. Fixed costFixed cost – – cost that do not vary in total amount as the sales cost that do not vary in total amount as the sales

volume or the quantity of output changes. Examples:volume or the quantity of output changes. Examples:a.a. Administrative salariesAdministrative salariesb.b. DepreciationDepreciationc.c. Insurance premiumsInsurance premiumsd.d. Property taxesProperty taxese.e. RentRent

2.2. Variable costVariable cost – cost that tend to vary in total as output – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples:changes. VC are fixed per unit of output. Examples:

a.a. Direct materialsDirect materialsb.b. Direct LaborDirect Laborc.c. Energy cost associated with productionEnergy cost associated with productiond.d. PackagingPackaginge.e. Freight-outFreight-outf.f. Sales commissionsSales commissions

Break-even AnalysisBreak-even Analysis

3.3. Semivariables costs (Semifixed cost)Semivariables costs (Semifixed cost) – cost – cost that exhibit the joint characteristics of both FC that exhibit the joint characteristics of both FC and VC over different ranges of output. and VC over different ranges of output. Examples: Salaries paid to production Examples: Salaries paid to production supervisors.supervisors.

Finding Break-even PointFinding Break-even Point

► The break-even is just a simple adaptation of The break-even is just a simple adaptation of the firm’s income statement expressed as:the firm’s income statement expressed as:

Profit (Profit (ππ) ) = Sales – (Total VC + Total FC)= Sales – (Total VC + Total FC)

► 3 ways to find BEP:3 ways to find BEP:a.a. Trial and ErrorTrial and Error

1)1) Select an arbitrary output levelSelect an arbitrary output level

2)2) Calculate the corresponding EBIT amountCalculate the corresponding EBIT amount

3)3) When EBIT = 0, BEP has been found.When EBIT = 0, BEP has been found.

Finding Break-even PointFinding Break-even Pointb.b. Contribution Margin AnalysisContribution Margin Analysis

1)1) Contribution Margin = Unit Selling Price – Unit VCContribution Margin = Unit Selling Price – Unit VC2)2) BEP (units) = BEP (units) = FC FC

contribution margin per unitcontribution margin per unit

c.c. Algebraic AnalysisAlgebraic Analysis1)1) QQBB = the break-even level of units = the break-even level of units

soldsoldPP = the unit sales price= the unit sales priceFF = the total FC for the period= the total FC for the periodVV = unit VC= unit VC

2)2) Then, Then, QQBB = = F F

P – V P – V


Example:Example:

Mutiara Corporation (MC) manufactures a Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360,000, how many dress fixed costs of RM 360,000, how many dress must MC sell to breakeven?must MC sell to breakeven?


Solutions:Solutions:

*unit variable cost (VC) = 70% x RM 30 = RM 21*unit variable cost (VC) = 70% x RM 30 = RM 21

QQBB = = F F

P – VP – V

= RM 360 000= RM 360 000 = = 40 000 unit40 000 unit

RM 30 – RM 21RM 30 – RM 21


►The BEP in sales dollars:The BEP in sales dollars: S* = S* = FF

1 – VC1 – VC

SS

Example:Example: SalesSales $ 300 000$ 300 000

(-) Total VC(-) Total VC 180 000 180 000

Revenue before FCRevenue before FC 120 000 120 000

(-) Total FC(-) Total FC 100 000 100 000

EBITEBIT $ 20 000 $ 20 000



S* = S* = FF = $ 100 000= $ 100 0001 – VC1 – VC 1 – $ 180 000 1 – $ 180 000

SS $ 300 000 $ 300 000

= $ 100 000= $ 100 000

1 – 0.601 – 0.60

= = $ 250 000$ 250 000

Degree of Operating LeverageDegree of Operating Leverage

►Degree of Operating Degree of Operating Leverage from the base = % change in EBITLeverage from the base = % change in EBIT sales level (DOLs) % change in Salessales level (DOLs) % change in Sales

►DOLs = DOLs = Q (P – V) Q (P – V) Q (P – V) – F Q (P – V) – F

►DOLs = revenue before FCDOLs = revenue before FC = S – VC = S – VC EBITEBIT S – VC – F S – VC – F


Example:Example:Avitar Corporation manufactures a line of Avitar Corporation manufactures a line of computer memory expansion boards used in computer memory expansion boards used in microcomputers. The average selling price of its microcomputers. The average selling price of its finished product is $175 per unit. The variable finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs cost for these same units is $115. Avitar incurs fixed costs of $650,000 per year. Avitar fixed costs of $650,000 per year. Avitar estimates the sales in next year will be 20,000 estimates the sales in next year will be 20,000 units. What is Avitar expected degree of units. What is Avitar expected degree of operating leverage?operating leverage?



DOLs = DOLs = Q (P – V) Q (P – V)

Q (P – V) – F Q (P – V) – F

= 20 000 ($ 175 – $ 115)= 20 000 ($ 175 – $ 115)

[20 000 ($ 175 – $ 115)] – $ 650 [20 000 ($ 175 – $ 115)] – $ 650 000000

= = 2.1818 times2.1818 times

Degree of Financial LeverageDegree of Financial Leverage

►DFL = DFL = % change in EPS% change in EPS > 1 > 1

% change in EBIT % change in EBIT

►DFLDFLEBITEBIT = = EBITEBIT

EBIT – IEBIT – I

* I = interest expense* I = interest expense

Degree of Financial LeverageDegree of Financial LeverageExample:Example:

SalesSales $ 600,000$ 600,000(-)(-) total VCtotal VC $ 200,000$ 200,000

Revenue before FCRevenue before FC $ 400,000$ 400,000(-)(-) total FCtotal FC $ 200,000$ 200,000

EBITEBIT $ 200,000$ 200,000(-)(-) interest expensesinterest expenses $ 50,000$ 50,000

EBTEBT $ 150,000$ 150,000Taxes (34%)Taxes (34%) $ 51,000$ 51,000Net Income (EAT)Net Income (EAT) $ 99,000$ 99,000

Degree of Financial LeverageDegree of Financial Leverage

Solutions:Solutions:What is the degree of financial leverage?What is the degree of financial leverage?

DFLDFLEBITEBIT = = EBITEBIT EBIT – IEBIT – I

= $ 200 000= $ 200 000 $ 200 000 – $ 50 000$ 200 000 – $ 50 000

= = 1.33 times1.33 times

Combination of Operating and Financial Combination of Operating and Financial LeverageLeverage

►DCL = % change in EPSDCL = % change in EPS

% change in Sales% change in Sales

►DCLs = (DOLs) x (DFLDCLs = (DOLs) x (DFLEBITEBIT))

►DCLs = DCLs = Q (P – V) Q (P – V)

Q (P – V) – F – I Q (P – V) – F – I

Planning the Firm’s Planning the Firm’s Financing MixFinancing Mix

Planning the Firm’s Financing MixPlanning the Firm’s Financing Mix

► Financial StructureFinancial Structure – the mix of all funds source that – the mix of all funds source that appear on the right side of the balance sheet.appear on the right side of the balance sheet.

► Capital StructureCapital Structure – the mix of long term – the mix of long term sources of sources of fundsfunds used by the firm. Basically, this concept omits used by the firm. Basically, this concept omits short-term liabilities. short-term liabilities.

► Financial Structure DesignFinancial Structure Design – the management activity – the management activity of seeking the proper mix of all financing components in of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds.order to minimize the cost of raising a given of funds.

► Optimal Capital StructureOptimal Capital Structure – the unique capital – the unique capital structure that minimizes the firm’s composite cost of structure that minimizes the firm’s composite cost of long term capital.long term capital.


1.1. EBIT-EPS indifference pointEBIT-EPS indifference point – the level of EBIT that will – the level of EBIT that will equate EPS between two difference financing plans. equate EPS between two difference financing plans.

EPS: Stock PlanEPS: Stock Plan EPS: Bond PlanEPS: Bond Plan

(EBIT – I) (1 – t) – P(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P

SsSs SSbb

* EBIT = earning before interest and taxes* EBIT = earning before interest and taxes

I I = interest expenses = interest expenses

tt = firm income tax rate = firm income tax rate

PP = preferred dividend paid = preferred dividend paid

SsSs = the number of common s/o under the stock plan = the number of common s/o under the stock plan

SSbb = the number of common s/o under the bond plan= the number of common s/o under the bond plan

Planning the Firm’s Financing MixPlanning the Firm’s Financing Mix2.2. Projected Income StatementProjected Income Statement

Alternative 1Alternative 1 Alternative 2Alternative 2EBITEBIT XXXXXXXXXXXX XXXXXX XXXXXX

(-) Interest(-) Interest XXXXX XXXXX XXXXX XXXXXEBTEBT XXXXXXXXXXXX XXXXXX XXXXXX

(-) Taxes(-) Taxes XXXXX XXXXX XXXXX XXXXXNet IncomeNet Income XXXXXXXXXXXX XXXXXX XXXXXX

SharesShares XXXXXXX XXXXXXX XXXXXXX XXXXXXXEPS*EPS* XXX XXX XXX XXX

*EPS = Net Income*EPS = Net Income Shares OutstandingShares Outstanding


Example:Example:ING Berhad is financed entirely with 800,000 shares of common 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 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 (8% 10 years bond). The company plans to raise an additional RM 2,000,000 to finance new project and considering two RM 2,000,000 to finance new project and considering two alternatives;alternatives;

Alternative 1: 200,000 new common shares sold Alternative 1: 200,000 new common shares sold to the public to the public

Alternative 2: Issue 10% bondAlternative 2: Issue 10% bond

Projected level of EBIT is at approximately RM 2,000,000. Projected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.Corporate tax rate is 28%.


Solutions:Solutions:i.i. Calculate the indifference level of EBIT between two Calculate the indifference level of EBIT between two

alternatives.alternatives.

* Plan Stock (alternative 1) * Plan Stock (alternative 1)

= Interest on bond = (1,000,000 x 8% = RM 80,000)= Interest on bond = (1,000,000 x 8% = RM 80,000)

Unit shares = 800,000 + 200,000 = 1,000,000Unit shares = 800,000 + 200,000 = 1,000,000

*Plan Bond (alternative 2)*Plan Bond (alternative 2)

= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)

Unit shares = 800,000Unit shares = 800,000


Plan StockPlan Stock Plan BondPlan Bond

(EBIT – I) (1 – t) – P(EBIT – I) (1 – t) – P = = (EBIT – I) (1 – t) – P (EBIT – I) (1 – t) – P

SsSs Sb Sb

(EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0(EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0

1,000,0001,000,000 800,000 800,000

0.72 EBIT – RM 57,6000.72 EBIT – RM 57,600 = = 0.72 EBIT – RM 201,600 0.72 EBIT – RM 201,600

1,000,0001,000,000 800,000 800,000

576,000 EBIT – RM 46,080,000,000 576,000 EBIT – RM 46,080,000,000 = = 720,000 EBIT – RM 201,600,000,000720,000 EBIT – RM 201,600,000,000

– – 144,000 EBIT144,000 EBIT = – RM 155,520,000,000 = – RM 155,520,000,000

EBITEBIT = = RM 1,080,000RM 1,080,000

Planning the Firm’s Financing MixPlanning the Firm’s Financing Mixii.ii. Prepare the projected income statement that proves EPS will be the same 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)regardless of the plan chosen at the EBIT level found in question (i)

Alternative 1 Alternative Alternative 1 Alternative 22

EBITEBIT RM 1,080,000 RM 1,080,000RM 1,080,000 RM 1,080,000

(-) Interest(-) Interest 80,000 80,000 280,000 280,000

EBTEBT 1,000,000 1,000,000 800,000 800,000

(-) Taxes (28%)(-) Taxes (28%) 280,000 280,000 224,000 224,000

Net IncomeNet Income 720,000 720,000 576,000 576,000

SharesShares 1,000,000 1,000,000 800,000800,000

EPS*EPS* 0.72 0.72 0.720.72

*EPS = Net Income*EPS = Net Income

Shares OutstandingShares Outstanding


iii.iii. Which plan will provide the highest EPS for the EBIT projected Which plan will provide the highest EPS for the EBIT projected level?level?

Alternative 1 Alternative 2Alternative 1 Alternative 2

EBITEBIT RM 2,000,000 RM 2,000,000RM 2,000,000 RM 2,000,000

(-) Interest(-) Interest 80,000 80,000 280,000 280,000

EBTEBT 1,920,000 1,920,000 1,720,000 1,720,000

(-) Taxes (28%)(-) Taxes (28%) 537,600 537,600 481,600 481,600

Net IncomeNet Income 1,382,400 1,382,400 1,238,400 1,238,400

SharesShares 1,000,000 1,000,000 800,000 800,000

EPS*EPS* 1.3824 1.3824 1.548 1.548

*EPS = Net Income*EPS = Net Income

Shares OutstandingShares Outstanding

LEVERAGE AND CAPITAL STRUCTURE. Business Risk and Financial Risk Risk – the likely variability...

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