1. Copyright © 2003 Pearson Education, Inc. Slide 11-0 Ch 11 Learning Goals 1.Operating, financial, and total leverage (causes & measures). 2.Business risk, financial risk & total risk. 3.Optimal capital structure. 4.Identifying the optimal capital structure.

2. Copyright © 2003 Pearson Education, Inc. Slide 11-1 Leverage A change in sales revenue often causes a _________________ percentage change in earnings. –Cause: __________________ costs –Name: “leverage”

3. Copyright © 2003 Pearson Education, Inc. Slide 11-2 Leverage Kinds of leverage (& their causes): –Operating leverage (fixed _______________ costs) –Financial leverage (fixed ________________ costs) –Total leverage (the product of the other two)

4. Copyright © 2003 Pearson Education, Inc. Slide 11-3 Leverage Generally, higher leverage means: –Increased ____________. –Increased potential __________________.

5. Copyright © 2003 Pearson Education, Inc. Slide 11-4 Operating Leverage

6. Copyright © 2003 Pearson Education, Inc. Slide 11-5 Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of ________________ to changes in __________________. DOL can be calculated by: –interval estimate –point estimate Operating Leverage

7. Copyright © 2003 Pearson Education, Inc. Slide 11-6 Financial Leverage

8. Copyright © 2003 Pearson Education, Inc. Slide 11-7 Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of ____________ (or net profit after tax) to changes in ___________. Like the DOL, DFL can be calculated by: –interval estimate –point estimate Financial Leverage

9. Copyright © 2003 Pearson Education, Inc. Slide 11-8 Total leverage can be viewed as the total impact of all fixed costs in the firm’s operating and financial structure. Total Leverage

10. Copyright © 2003 Pearson Education, Inc. Slide 11-9 DTL = DOL x DFL Total Leverage Degree of Total Leverage The relationship between the DTL, DOL & DFL:

11. Copyright © 2003 Pearson Education, Inc. Slide 11-10 Capital Structure The firm’s capital structure is the mix of debt and equity it uses to finance fixed assets. There is an optimal, or __________________ capital structure for each firm.

12. Copyright © 2003 Pearson Education, Inc. Slide 11-11 Capital Structure The optimal capital structure balances the ____________________ of debt with the ________________ of debt financing.

13. Copyright © 2003 Pearson Education, Inc. Slide 11-12 Capital Structure The optimal capital structure for a particular firm depends on: – its business _____________ –the ___________________________ of its owners and managers

14. Copyright © 2003 Pearson Education, Inc. Slide 11-13 Determinants of Business Risk High business risk is the result of high fixed operating costs (high ______) unstable demand for firm’s products volatile costs (raw materials, for example)

15. Copyright © 2003 Pearson Education, Inc. Slide 11-14 Financial Risk Financial risk is the risk that the firm cannot meet its financial obligations.

16. Copyright © 2003 Pearson Education, Inc. Slide 11-15 Financial Risk Indicators of financial risk –High ____________ –High debt ratio –Low coverage ratios (times interest earned, etc.)

17. Copyright © 2003 Pearson Education, Inc. Slide 11-16 Capital Structure The total risk a firm faces (and the probability of bankruptcy) are the result of both business risk and financial risk. Probability of Bankruptcy

18. Copyright © 2003 Pearson Education, Inc. Slide 11-17 Capital Structure Firms with high business risk should use _____________ debt financing. As a result, the optimal capital structure is not the same for all industries or firms.

19. Copyright © 2003 Pearson Education, Inc. Slide 11-18 Capital Structure The optimal capital structure results in: –Minimum ____________ –Maximum _____________

20. Copyright © 2003 Pearson Education, Inc. Slide 11-19 Graphically WACC k Debt Ratio 0 Target Capital Structure The Optimal Capital Structure

21. Copyright © 2003 Pearson Education, Inc. Slide 11-20 Graphically Stock Price ($) Debt Ratio 0 Target Capital Structure P($) The Optimal Capital Structure

22. Copyright © 2003 Pearson Education, Inc. Slide 11-21 Analyzing Capital Structure To compare alternative optimal capital structures: (1)Estimate eps for each (2)Estimate resulting stock price for each (3)Pick the one with highest stock price Or (1)Estimate WACC for each (2)Pick the one with lowest WACC