CHAPTER 11 and 14 LEVERAGE AND CAPITAL STRUCTURE

CHAPTER 11 and 14 LEVERAGE AND CAPITAL STRUCTURE

Business Risk and Financial Risk • • Risk – the likely variability associated with expected revenue streams. The variations in the income stream can be attributed to: a. The firm’s exposure to business risk b. The firm’s decision to incur financial risk Business Risk – the risk that comes from the nature of the firm’s operating activities. Financial Risk – the risk that comes from the financial policy (i. e capital structure) of the firm. SITI AISHAH BINTI KASSIM (FM 2) 2

Financial and Operating Leverage • Financial Leverage – the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs. • Operating Leverage – the incurrence of fixed operating costs in the firm’s income stream. SITI AISHAH BINTI KASSIM (FM 2) 3

Break-even Analysis • • Objective – to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit. • The break-even quantity of output results in an EBIT level = 0 Some actual and potential applications of BEP include: a. Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models. b. Pricing policy c. Labor contract negotiations d. Evaluation of cost structure e. Financial decision making SITI AISHAH BINTI KASSIM (FM 2) 4

Break-even Analysis • Essential elements of the break-even model: 1. Fixed cost – cost that do not vary in total amount as the sales volume or the quantity of output changes. Examples: a. b. c. d. e. 2. Administrative salaries Depreciation Insurance premiums Property taxes Rent Variable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples: a. b. c. d. e. f. Direct materials Direct Labor Energy cost associated with production Packaging Freight-out Sales commissions SITI AISHAH BINTI KASSIM (FM 2) 5

Break-even Analysis 3. Semivariables costs (Semifixed cost) – cost that exhibit the joint characteristics of both FC and VC over different ranges of output. Examples: Salaries paid to production supervisors. SITI AISHAH BINTI KASSIM (FM 2) 6

Finding Break-even Point • The break-even is just a simple adaptation of the firm’s income statement expressed as: – Profit (π) = Sales – (Total VC + Total FC) • 3 ways to find BEP: a. Trial and Error 1) Select an arbitrary output level 2) Calculate the corresponding EBIT amount 3) When EBIT = 0, BEP has been found. SITI AISHAH BINTI KASSIM (FM 2) 7

Finding Break-even Point b. Contribution Margin Analysis 1) Contribution Margin = Unit Selling Price – Unit VC 2) BEP (units) = FC contribution margin per unit c. Algebraic Analysis 1) QB P F V 2) Then, = the break-even level of units sold = the unit sales price = the total FC for the period = unit VC QB = F P–V SITI AISHAH BINTI KASSIM (FM 2) 8

Finding Break-even Point Example: Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360, 000, how many dress must MC sell to breakeven? SITI AISHAH BINTI KASSIM (FM 2) 9

Finding Break-even Point Solutions: *unit variable cost (VC) = 70% x RM 30 = RM 21 QB = = F P–V RM 360 000 = 40 000 unit RM 30 – RM 21 SITI AISHAH BINTI KASSIM (FM 2) 10

Finding Break-even Point • The BEP in sales dollars: – S* = F 1 – VC S Example: Sales (-) Total VC Revenue before FC (-) Total FC EBIT SITI AISHAH BINTI KASSIM (FM 2) $ 300 000 180 000 120 000 100 000 $ 20 000 11

Finding Break-even Point Solutions: S* = F 1 – VC S = $ 100 000 1 – $ 180 000 $ 300 000 = $ 100 000 1 – 0. 60 = $ 250 000 SITI AISHAH BINTI KASSIM (FM 2) 12

Degree of Operating Leverage • Degree of Operating Leverage from the base = % change in EBIT sales level (DOLs) % change in Sales • DOLs = Q (P – V) – F • DOLs = revenue before FC EBIT SITI AISHAH BINTI KASSIM (FM 2) = S – VC – F 13

Degree of Operating Leverage Example: Avitar Corporation manufactures a line of computer memory expansion boards used in microcomputers. The average selling price of its finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650, 000 per year. Avitar estimates the sales in next year will be 20, 000 units. What is Avitar expected degree of operating leverage? SITI AISHAH BINTI KASSIM (FM 2) 14

Degree of Operating Leverage Solutions: DOLs = Q (P – V) – F = 20 000 ($ 175 – $ 115) [20 000 ($ 175 – $ 115)] – $ 650 000 = 2. 1818 times SITI AISHAH BINTI KASSIM (FM 2) 15

Degree of Financial Leverage • DFL = % change in EPS % change in EBIT • DFLEBIT = >1 EBIT – I * I = interest expense SITI AISHAH BINTI KASSIM (FM 2) 16

Degree of Financial Leverage Example: Sales (-) total VC Revenue before FC (-) total FC EBIT (-) interest expenses EBT Taxes (34%) Net Income (EAT) SITI AISHAH BINTI KASSIM (FM 2) $ 600, 000 $ 200, 000 $ 400, 000 $ 200, 000 $ 50, 000 $ 150, 000 $ 51, 000 $ 99, 000 17

Degree of Financial Leverage Solutions: What is the degree of financial leverage? DFLEBIT = EBIT – I = $ 200 000 – $ 50 000 = 1. 33 times SITI AISHAH BINTI KASSIM (FM 2) 18

Combination of Operating and Financial Leverage • DCL = % change in EPS % change in Sales • DCLs = (DOLs) x (DFLEBIT) • DCLs = Q (P – V) – F – I SITI AISHAH BINTI KASSIM (FM 2) 19

Planning the Firm’s Financing Mix

Planning the Firm’s Financing Mix • Financial Structure – the mix of all funds source that appear on the right side of the balance sheet. • Capital Structure – the mix of long term sources of funds used by the firm. Basically, this concept omits short -term liabilities. • Financial Structure Design – the management activity of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds. • Optimal Capital Structure – the unique capital structure that minimizes the firm’s composite cost of long term capital. SITI AISHAH BINTI KASSIM (FM 2) 21

1. Planning the Firm’s Financing Mix EBIT-EPS indifference point – the level of EBIT that will equate EPS between two difference financing plans. EPS: Stock Plan EPS: Bond Plan (EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P Ss Sb * EBIT = earning before interest and taxes I = interest expenses t = firm income tax rate P = preferred dividend paid Ss = the number of common s/o under the stock plan Sb = the number of common s/o under the bond plan SITI AISHAH BINTI KASSIM (FM 2) 22

2. Planning the Firm’s Financing Mix Projected Income Statement Alternative 1 EBIT XXXXXX (-) Interest XXXXX EBT XXXXXX (-) Taxes XXXXX Net Income XXXXXX Shares XXXXXXX EPS* XXX Alternative 2 XXXXXX XXXXXXX XXX *EPS = Net Income Shares Outstanding SITI AISHAH BINTI KASSIM (FM 2) 23

Planning the Firm’s Financing Mix Example: ING Berhad is financed entirely with 800, 000 shares of common stock priced at RM 5 per unit and RM 1, 000 worth of debt (8% 10 years bond). The company plans to raise an additional RM 2, 000 to finance new project and considering two alternatives; Alternative 1: 200, 000 new common shares sold to the public Alternative 2: Issue 10% bond Projected level of EBIT is at approximately RM 2, 000. Corporate tax rate is 28%. SITI AISHAH BINTI KASSIM (FM 2) 24

Planning the Firm’s Financing Mix Solutions: i. Calculate the indifference level of EBIT between two alternatives. * Plan Stock (alternative 1) = Interest on bond = (1, 000 x 8% = RM 80, 000) Unit shares = 800, 000 + 200, 000 = 1, 000 *Plan Bond (alternative 2) = Interest on bond = RM 80, 000 + (RM 2, 000 x 10% = RM 280, 000) Unit shares = 800, 000 SITI AISHAH BINTI KASSIM (FM 2) 25

Planning the Firm’s Financing Mix Plan Stock Plan Bond (EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P Ss Sb (EBIT – 80, 000) (1 – 0. 28) – 0 = (EBIT – 280, 000) (1 – 0. 28) - 0 1, 000 800, 000 0. 72 EBIT – RM 57, 600 = 0. 72 EBIT – RM 201, 600 1, 000 800, 000 576, 000 EBIT – RM 46, 080, 000 = 720, 000 EBIT – RM 201, 600, 000 – 144, 000 EBIT = – RM 155, 520, 000 EBIT = RM 1, 080, 000 SITI AISHAH BINTI KASSIM (FM 2) 26

Planning the Firm’s Financing Mix ii. Prepare the projected income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in question (i) Alternative 1 Alternative 2 EBIT RM 1, 080, 000 (-) Interest 80, 000 280, 000 EBT 1, 000 800, 000 (-) Taxes (28%) 280, 000 224, 000 Net Income 720, 000 576, 000 Shares 1, 000 800, 000 EPS* 0. 72 *EPS = Net Income Shares Outstanding SITI AISHAH BINTI KASSIM (FM 2) 27

Planning the Firm’s Financing Mix iii. Which plan will provide the highest EPS for the EBIT projected level? EBIT (-) Interest EBT (-) Taxes (28%) Net Income Shares EPS* Alternative 1 RM 2, 000 80, 000 1, 920, 000 537, 600 1, 382, 400 1, 000 1. 3824 Alternative 2 RM 2, 000 280, 000 1, 720, 000 481, 600 1, 238, 400 800, 000 1. 548 *EPS = Net Income Shares Outstanding SITI AISHAH BINTI KASSIM (FM 2) 28

THE END SITI AISHAH BINTI KASSIM (FM 2)