Ch. 10: Determining the Financing Mix How do we want to finance our firm’s assets?  MF 

Determining the Financing Mix n Operating Leverage n Financial Leverage n Capital Structure

What is Leverage?

2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT).

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

Business Risk Affected by: n Sales volume variability n Competition n Cost variability n Product diversification n Product demand n Operating Leverage

Operating Leverage n The use of fixed operating costs as opposed to variable operating costs. n A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

EBIT OperatingLeverage

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders

Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage. FIRM EBIT EPS Stock-holders

Financial Leverage n The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

EPS Financial Leverage

Breakeven Analysis n Illustrates the effects of operating leverage. n Useful for forecasting the profitability of a firm, division or product line. n Useful for analyzing the impact of changes in fixed costs, variable costs, and sales price.

Quantity $ Breakeven Analysis

Quantity $ Total Revenue

Costs n Suppose the firm has both fixed operating costs (administrative salaries, insurance, rent, property tax) and variable operating costs (materials, labor, energy, packaging, sales commissions).

Quantity$

Quantity $ Total Revenue

Quantity { $ Total Cost FC

Quantity { $ Total Revenue Total Cost FC Q1Q1 + - } EBIT

Quantity { $ Total Revenue Total Cost FC Break-evenpoint Q1Q1 + - } EBIT

Operating Leverage n What happens if the firm increases its fixed operating costs and reduces (or eliminates) its variable costs?

Quantity { $ Total Revenue Total Cost FC Break-evenpoint Q1Q1 + - } EBIT

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT

Quantity { $ Total Revenue Total Cost = Fixed FC Break-evenpoint } Q1Q1Q1Q1 + - EBIT Trade-off: the firm has a higher breakeven point. If sales are not high enough, the firm will not meet its fixed expenses!

Breakeven Calculations

Breakeven point (units of output) QB =QB =QB =QB = F P - V

Breakeven Calculations Breakeven point (units of output) n Q B = breakeven level of Q. n F = total anticipated fixed costs. n P = sales price per unit. n V = variable cost per unit. QB =QB =QB =QB = F P - V

Breakeven Calculations S* = F VC VC S 1 - Breakeven point (sales dollars)

n S* = breakeven level of sales. n F = total anticipated fixed costs. n S = total sales. n VC = total variable costs. Breakeven Calculations S* = F VC VC S 1 -

Analytical Income Statement sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income

sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income } contribution margin Analytical Income Statement

sales sales - variable costs - fixed costs operating income operating income - interest EBT EBT - taxes net income net income } contribution margin Analytical Income Statement EBT (1 - t) = Net Income, EBT (1 - t) = Net Income, so, so, Net Income / (1 - t) = EBT Net Income / (1 - t) = EBT EBT (1 - t) = Net Income, EBT (1 - t) = Net Income, so, so, Net Income / (1 - t) = EBT Net Income / (1 - t) = EBT

Degree of Operating Leverage (DOL) n Operating leverage: by using fixed operating costs, a small change in sales revenue is magnified into a larger change in operating income. n This “multiplier effect” is called the degree of operating leverage.

DOLs = % change in EBIT % change in sales Degree of Operating Leverage from Sales Level (S)

DOLs = % change in EBIT % change in sales change in EBIT EBIT EBIT change in sales sales sales = Degree of Operating Leverage from Sales Level (S)

n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S)

DOLs = Sales - Variable Costs EBIT EBIT n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S)

n If we have the data, we can use this formula: Degree of Operating Leverage from Sales Level (S) Q(P - V) Q(P - V) Q(P - V) - F = DOLs = Sales - Variable Costs EBIT EBIT

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT).

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

What does this tell us? n If DOL = 2, then a 1% increase in sales will result in a 2% increase in operating income (EBIT). Stock- holders EBIT EPS Sales

Degree of Financial Leverage (DFL) n Financial leverage: by using fixed cost financing, a small change in operating income is magnified into a larger change in earnings per share. n This “multiplier effect” is called the degree of financial leverage.

DFL = % change in EPS % change in EBIT Degree of Financial Leverage

DFL = % change in EPS % change in EBIT change in EPS EPS EPS change in EBIT EBIT EBIT Degree of Financial Leverage =

n If we have the data, we can use this formula:

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I n If we have the data, we can use this formula:

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share.

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales

What does this tell us? n If DFL = 3, then a 1% increase in operating income will result in a 3% increase in earnings per share. Stock- holders EBIT EPS Sales

Degree of Combined Leverage (DCL) n Combined leverage: by using operating leverage and financial leverage, a small change in sales is magnified into a larger change in earnings per share. n This “multiplier effect” is called the degree of combined leverage.

Degree of Combined Leverage

DCL = DOL x DFL Degree of Combined Leverage

DCL = DOL x DFL % change in EPS % change in Sales Degree of Combined Leverage =

DCL = DOL x DFL % change in EPS % change in Sales Degree of Combined Leverage = change in EPS EPS EPS change in Sales Sales Sales =

Degree of Combined Leverage n If we have the data, we can use this formula:

DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I n If we have the data, we can use this formula: Degree of Combined Leverage

DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I n If we have the data, we can use this formula: Q(P - V) Q(P - V) Q(P - V) - F - I Q(P - V) - F - I =

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share.

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales

What does this tell us? n If DCL = 4, then a 1% increase in sales will result in a 4% increase in earnings per share. Stock- holders EBIT EPS Sales

In-class Project: n Based on the following information on Levered Company, answer these questions: 1) If sales increase by 10%, what should happen to operating income? 2) If operating income increases by 10%, what should happen to EPS? 3) If sales increase by 10%, what should be the effect on EPS?

Levered Company Sales (100,000 units)$1,400,000 Variable Costs $800,000 Fixed Costs $250,000 Interest paid $125,000 Tax rate 34% Common shares outstanding 100,000

Sales EBIT EPS DOL DFL DCL Leverage

Levered Company Sales EBIT EPS DOL = DFL DCL

Degree of Operating Leverage from Sales Level (S) DOLs = Sales - Variable Costs EBIT EBIT

Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = DOLs = Sales - Variable Costs EBIT EBIT

Degree of Operating Leverage from Sales Level (S) 1,400, ,000 1,400, , , ,000 = = DOLs = Sales - Variable Costs EBIT EBIT

Levered Company Sales EBIT EPS DOL = DFL = DCL

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000

Degree of Financial Leverage DFL = EBIT EBIT EBIT - I = 350, , , ,000 = 1.556

Levered Company Sales EBIT EPS DOL = DFL = DCL

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 =

Degree of Combined Leverage DCL = Sales - Variable Costs Sales - Variable Costs EBIT - I EBIT - I 1,400, ,000 1,400, , , ,000 = =

Levered Company Sales EBIT EPS DOL = DFL = DCL = 2.667

Sales (110,000 units)1,540,000 Sales (110,000 units)1,540,000 Variable Costs (880,000) Variable Costs (880,000) Fixed Costs (250,000) Fixed Costs (250,000) EBIT 410,000 ( %) EBIT 410,000 ( %) Interest (125,000) Interest (125,000) EBT 285,000 EBT 285,000 Taxes (34%) (96,900) Taxes (34%) (96,900) Net Income 188,100 Net Income 188,100 EPS $1.881 ( %) EPS $1.881 ( %) Levered Company 10% increase in sales