Leverage & Capital Structure

Leverage A firm is said to be leveraged if it has fixed costs. There are two types of leverage: Operating leverage – fixed costs associated with running the firm. Financial leverage – fixed costs associated with financing the firm. Degree of leverage Measure of how much leverage the firm uses.

Capital Structure The mix of long-term financial sources used to finance the firm. It usually refers to the specific proportions of debt, equity, preferred stock, etc. used to finance the firm. Only long-term sources are included.

Breakeven Analysis Finding the level of operations necessary to cover all costs. Can also be used to analyze the level of profitability associated with differing levels of sales. Operating breakeven point: The level of sales necessary to cover all operating costs: The points where EBIT = $0.

A Stylized Approach The algebra: PQ-VQ-F=EBIT (P-V)Q-F=EBIT Solving for Q when EBIT = $0: Q=F/(P-V) Practical problem: Most companies don’t sell only one product/service, and therefore quantity is not as reliable as sales volume.

Graphical Approach

Operating Leverage Operating leverage is the use of fixed operating costs to magnify the effects of changes in sales to the firm’s operating earnings. Operating leverage is particularly useful if the firm can substitute variable for fixed costs.

Measuring Op. Leverage Degree of Operating Leverage: Note: As DOL increases, volatility in EBIT (operating earnings) increases.

Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effects of changes in sales to the firm’s net earnings. Sources of financial leverage are primarily debt and preferred stock.

Measuring Fin. Leverage Degree of Financial Leverage: Note: As DFL increases, volatility in net earnings increases.

Total Leverage Total leverage is the use of any fixed costs to magnify the effect of changes in sales on the firm’s net earnings. The two components of total leverage are operating and financial leverage. Categorizing two components depend on where on the income statement the fixed cost is found.

Measuring Total Leverage Degree of Total Leverage: Note: DTL = DOL×DFL.

Capital Structure Theory From WACC we know that the most expensive sources of capital are equity (common stock and retained earnings). From leverage analysis, we know that adding debt adds risk. Adding risk adds cost to WACC. Therefore adding debt will increase its cost, and the cost of equity.

The goal of the financial manager is to maximize shareholder wealth: What level of debt will maximize the value of the firm to the shareholder?

How Much Debt? The optimal debt level depends on: Tax Benefit Tax shield is a component of WACC Any other tax shields? Probability of Bankruptcy Business Risk Revenue Stability Cost Stability Level of Fixed Operating Costs

The optimal debt level depends on: Agency Costs Risk of expropriation Place monitoring costs on managers These monitoring costs can reduce the monitoring costs for equity investors as well.

Other Considerations Pecking Order Theory: 1) U se retained earnings 2) I ssue more debt 3) I ssue common equity Signaling Asymmetric information Debt is generally seen as a positive signal Depends on rates and terms

The Optimal Capital Structure

Contrast EPS Method The EPS-EBIT approach to capital structure involves selecting the capital structure that maximizes EPS over the expected range of EBIT. Using this approach, the emphasis is on maximizing the owners returns (EPS). A major shortcoming of this approach is the fact that earnings are only one of the determinants of shareholder wealth maximization. This method does not explicitly consider the impact of risk.

EPS-EBIT Approach to Capital Structure (cont.)

EPS Shortcoming Although EPS maximization is generally good for the firm’s shareholders, the basic shortcoming of this method is that it does not necessary maximize shareholder wealth because it fails to consider risk. If shareholders did not require risk premiums (additional return) as the firm increased its use of debt, a strategy focusing on EPS maximization would work. Unfortunately, this is not the case.