Chapter 7. Leverage and Capital Structure

Size: px

Start display at page:

Download "Chapter 7. Leverage and Capital Structure"

John Jefferson
6 years ago
Views:

1 Chapter 7 Leverage and Capital Structure

2 INTRODUCTION Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-2

3 It also increases the company's returns; specifically its return on equity. This is true because, if debt financing is used rather than equity financing, then the owner's equity is not diluted by issuing more shares of stock. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-3

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. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-4

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. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-6

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. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-7

8 OPERATING LEVERAGE Operating leverage can be defined as the potential use of fixed operating costs to magnify the effects of changes in sales on the firm s earnings before interest and taxes. Copyright 2006 Pearson Addison-Wesley. All rights reserved. 11-8

10 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

11 Operating Leverage: Measuring the Degree of Operating Leverage (cont) DOL = Percentage change in EBIT Percentage change in Sales Applying this equation to cases 1 and 2 in Table 12.4 yields: Case 1: DOL = (+100% +50%) = 2.0 Case 2: DOL = (-100% -50%) = 2.0 Copyright 2006 Pearson Addison-Wesley. All rights reserved

12 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

13 Financial Leverage (cont.) 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). Copyright 2006 Pearson Addison-Wesley. All rights reserved

15 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

16 Financial Leverage: Measuring the Degree of Financial Leverage (cont) DFL = Percentage change in EPS Percentage change in EBIT Applying this equation to cases 1 and 2 in Table 12.6 yields: Case 1: DFL = (+100% +40%) = 2.5 Case 2: DFL = (-100% -40%) = 2.5 Copyright 2006 Pearson Addison-Wesley. All rights reserved

17 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

18 Total Leverage (cont.) 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

20 Total Leverage: The Relationship of Operating, Financial and Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL Copyright 2006 Pearson Addison-Wesley. All rights reserved

21 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. Copyright 2006 Pearson Addison-Wesley. All rights reserved

22 In simple terms it can be stated that, minimising the weighted average cost of capital allows management to undertake a large number of profitable projects, thereby further increasing the value of the firm. Copyright 2006 Pearson Addison-Wesley. All rights reserved

The Money Supply Model

The Money Supply Model Define money as currency plus checkable deposits: M1 The Fed can control the monetary base better than it can control reserves Link the money supply (M) to the monetary base (MB)