1. Copyright © 2009 Pearson Prentice Hall. All rights reserved. Chapter 11 Leverage and Capital Structure

2. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-2 Learning Goals 1.Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on it. 2.Understand operating, financial, and total leverage and the relationship among them. 3..

3. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-3 Learning Goals 4.Explain the optimal capital structure using a graphical view of the firm’s cost of capital functions and a zero- growth valuation model. 5.. 6.Review the return and risk of alternative capital structures, their linkage to market value, and other important capital structure considerations related to capital structure.

4. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-4 Leverage Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return. The amount of leverage in the firm’s capital structure—the mix of debt and equity—can significantly affect its value by affecting risk and return.

5. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-5 Leverage (cont.) Table 11.1 General Income Statement Format and Types of Leverage

6. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-6 Breakeven Analysis Breakeven (cost-volume-profit) analysis is used to: –determine the level of operations necessary to cover all operating costs, and –evaluate the profitability associated with various levels of sales. The firm’s operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses. At the OBP, operating profit (EBIT) is equal to zero.

7. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-7 Breakeven Analysis (cont.) To calculate the OBP, cost of goods sold and operating expenses must be categorized as fixed or variable. Variable costs vary directly with the level of sales and are a function of volume, not time. Examples would include direct labor and shipping. Fixed costs are a function of time and do not vary with sales volume. Examples would include rent and fixed overhead.

8. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-8 P = sales price per unit Q = sales quantity in units FC=fixed operating costs per period VC= variable operating costs per unit EBIT = (P x Q) - FC - (VC x Q) Breakeven Analysis: Algebraic Approach Letting EBIT = 0 and solving for Q, we get: Using the following variables, the operating portion of a firm’s income statement may be recast as follows:

9. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-9 Breakeven Analysis: Algebraic Approach (cont.)

10. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-10 Q= $2,500= 500 posters $10 - $5 Breakeven Analysis: Algebraic Approach (cont.) This implies that if Cheryl’s sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0). Example: Cheryl’s Posters has fixed operating costs of $2,500, a sales price of $10 per poster, and variable costs of $5 per poster. Find the OBP.

11. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-11 Breakeven Analysis: Graphical Approach Figure 11.1 Breakeven Analysis

12. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-12 Operating Leverage (cont.) Table 11.4 The EBIT for Various Sales Levels

13. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-13 Operating Leverage: Measuring the Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales. A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL. Only companies that use fixed costs in the production process will experience operating leverage.

14. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-14 DOL = Percentage change in EBIT Percentage change in Sales Case 1: DOL = (+100% ÷ +50%) = 2.0 Case 2: DOL = (-100% ÷ -50%) = 2.0 Operating Leverage: Measuring the Degree of Operating Leverage (cont) Applying this equation to cases 1 and 2 in Table 12.4 yields:

15. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-15 DOL at base Sales level Q = Q X (P – VC) Q X (P – VC) – FC Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 yields the following result: DOL at 1,000 units = 1,000 X ($10 - $5) = 2.0 1,000 X ($10 - $5) - $2,500 Operating Leverage: Measuring the Degree of Operating Leverage (cont) A more direct formula for calculating DOL at a base sales level, Q, is shown below.

16. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-16 Assume that Cheryl’s Posters exchanges a portion of its variable operating costs for fixed operating costs by eliminating sales commissions and increasing sales salaries. This exchange results in a reduction in variable costs per unit from $5.00 to $4.50 and an increase in fixed operating costs from $2,500 to $3,000 DOL at 1,000 units = 1,000 X ($10 - $4.50) = 2.2 1,000 X ($10 - $4.50) - $2,500 Operating Leverage: Fixed Costs and Operating Leverage

17. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-17 Operating Leverage: Fixed Costs and Operating Leverage (cont.) Table 11.5 Operating Leverage and Increased Fixed Costs

18. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-18 Financial Leverage Financial leverage results from the presence of fixed financial costs in the firm’s income stream. Financial leverage can therefore be defined as the potential use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS. The two fixed financial costs most commonly found on the firm’s income statement are (1) interest on debt and (2) preferred stock dividends.

19. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-19 Chen Foods, a small Oriental food company, expects EBIT of $10,000 in the current year. It has a $20,000 bond with a 10% annual coupon rate and an issue of 600 shares of $4 annual dividend preferred stock. It also has 1,000 share of common stock outstanding. The annual interest on the bond issue is $2,000 (10% x $20,000). The annual dividends on the preferred stock are $2,400 ($4/share x 600 shares). Financial Leverage (cont.)

20. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-20 Financial Leverage (cont.) Table 11.6 The EPS for Various EBIT Levels a

21. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-21 Financial Leverage: Measuring the Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. Like the DOL, DFL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DFL. Only companies that use debt or other forms of fixed cost financing (like preferred stock) will experience financial leverage.

22. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-22 DFL = Percentage change in EPS Percentage change in EBIT Case 1: DFL = (+100% ÷ +40%) = 2.5 Case 2: DFL = (-100% ÷ -40%) = 2.5 Applying this equation to cases 1 and 2 in Table 12.6 yields: Financial Leverage: Measuring the Degree of Financial Leverage (cont)

23. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-23 DFL at base level EBIT = EBIT EBIT – I – [PD x 1/(1-T)] Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and the tax rate, T = 40% yields the following result: DFL at $10,000 EBIT = $10,000 $10,000 – $2.000 – [$2,400 x 1/(1-.4)] DFL at $10,000 EBIT = 2.5 A more direct formula for calculating DFL at a base level of EBIT is shown below. Financial Leverage: Measuring the Degree of Financial Leverage (cont)

24. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-24 Total Leverage Total leverage results from the combined effect of using fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure.

25. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-25 Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: variable operating costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000, and preferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding. Table 12.7 on the following slide summarizes these figures. Total Leverage (cont.)

26. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-26 DTL = Percentage change in EPS Percentage change in Sales Degree of Total Leverage (DTL) = (300% ÷ 50%) = 6.0 Total Leverage: Measuring the Degree of Total Leverage Applying this equation to the data Table 12.7 yields:

27. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-27 DTL at base sales level = Q x (P – VC) Q x (P – VC) – FC – I – [PD x 1/(1-T)] Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and the tax rate, T = 40% yields the following result: DTL at 20,000 units = $60,000/$10,000 = 6.0 DTL at 20,000 units = 20,000 X ($5 – $2) 20,000 X ($5 – $2) – $10,000 – $20,000 – [$12,000 x 1/(1-.4)] A more direct formula for calculating DTL at a base level of Sales, Q, is shown below. Total Leverage: Measuring the Degree of Total Leverage (cont.)

28. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-28 DTL = DOL x DFL The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = 1.2 X 5.0 = 6.0 Applying this to our previous example we get: Total Leverage: The Relationship of Operating, Financial and Total Leverage

29. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-29 Total Leverage (cont.) Table 11.7 The Total Leverage Effect

30. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-30 The Firm’s Capital Structure Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. Poor capital structure decisions can result in a high cost of capital, thereby lowering project NPVs and making them more unacceptable. Effective decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of the firm.

31. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-31 Capital Structure Theory According to finance theory, firms possess a target capital structure that will minimize its cost of capital. Unfortunately, theory can not yet provide financial mangers with a specific methodology to help them determine what their firm’s optimal capital structure might be. Theoretically, however, a firm’s optimal capital structure will just balance the benefits of debt financing against its costs.

32. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-32 The major benefit of debt financing is the tax shield provided by the federal government regarding interest payments. The costs of debt financing result from: –the increased probability of bankruptcy caused by debt obligations, –the agency costs resulting from lenders monitoring the firm’s actions, and –the costs associated with the firm’s managers having more information about the firm’s prospects than do investors (asymmetric information). Capital Structure Theory (cont.)

33. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-33 Capital Structure Theory: Tax Benefits Allowing companies to deduct interest payments when computing taxable income lowers the amount of corporate taxes. This in turn increases firm cash flows and makes more cash available to investors. In essence, the government is subsidizing the cost of debt financing relative to equity financing.

34. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-34 Capital Structure Theory: Probability of Bankruptcy The probability that debt obligations will lead to bankruptcy depends on the level of a company’s business risk and financial risk. Business risk is the risk to the firm of being unable to cover operating costs. In general, the higher the firm’s fixed costs relative to variable costs, the greater the firm’s operating leverage and business risk. Business risk is also affected by revenue and cost stability.

35. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-35 Capital Structure Theory: Probability of Bankruptcy (cont.) The firm’s capital structure—the mix between debt versus equity—directly impacts financial leverage. Financial leverage measures the extent to which a firm employs fixed cost financing sources such as debt and preferred stock. The greater a firm’s financial leverage, the greater will be its financial risk—the risk of being unable to meet its fixed interest and preferred stock dividends.

36. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-36 Capital Structure Theory: Agency Costs Imposed by Lenders When a firm borrows funds by issuing debt, the interest rate charged by lenders is based on the lender’s assessment of the risk of the firm’s investments. After obtaining the loan, the firm’s stockholders and/or managers could use the funds to invest in riskier assets. If these high risk investments pay off, the stockholders benefit but the firm’s bondholders are locked in and are unable to share in this success.

37. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-37 To avoid this, lenders impose various monitoring costs on the firm. Examples would of these monitoring costs would: –include raising the rate on future debt issues, –denying future loan requests, –imposing restrictive bond provisions. Capital Structure Theory: Agency Costs Imposed by Lenders (cont.)

38. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-38 Suppose management has identified an extremely lucrative investment opportunity and needs to raise capital. Based on this opportunity, management believes its stock is undervalued since the investors have no information about the investment. Capital Structure Theory: Asymmetric Information Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. Asymmetric information can impact the firm’s capital structure as follows:

39. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-39 In this case, management will raise the funds using debt since they believe/know the stock is undervalued (underpriced) given this information. In this case, the use of debt is viewed as a positive signal to investors regarding the firm’s prospects. Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. Asymmetric information can impact the firm’s capital structure as follows: Capital Structure Theory: Asymmetric Information (cont.)

40. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-40 Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. Asymmetric information can impact the firm’s capital structure as follows: Capital Structure Theory: Asymmetric Information (cont.) On the other hand, if the outlook for the firm is poor, management will issue equity instead since they believe/know that the price of the firm’s stock is overvalued (overpriced). Issuing equity is therefore generally thought of as a “negative” signal.

41. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-41 The Optimal Capital Structure In general, it is believed that the market value of a company is maximized when the cost of capital (the firm’s discount rate) is minimized.

42. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-42 The Optimal Capital Structure Figure 11.3 Cost Functions and Value

43. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-43 Table 11.9 Basic Information on JSG Company’s Current and Alternative Capital Structures

44. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-44 EPS-EBIT Approach to Capital Structure 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.

45. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-45 Example EBIT-EPS coordinates can be found by assuming specific EBIT values and calculating the EPS associated with them. Such calculations for three capital structures—debt ratios of 0%, 30%, and 60%—for Cooke Company were presented earlier in Table 12.2. For EBIT values of $100,000 and $200,000, the associated EPS values calculated are summarized in the table with Figure 12.6. EPS-EBIT Approach to Capital Structure (cont.)

46. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 11-46 Table 11.10 Calculation of Share Value Estimates Associated with Alternative Capital Structures for JSG Company