Capital Structure Decisions 8

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CHAPTER 8 Capital Structure Decisions



© 2012 Pearson Prentice Hall. All rights reserved. 12-2

Objectives

• Discuss leverage, capital structure, breakevenanalysis, the operating breakeven point, and the effectof changing costs on the breakeven point.

• Understand operating, financial, and total leverageand the relationships among them.

• Describe the types of capital and the externalassessment of capital structure.




Leverage

Leverage refers to the effects that fixed costs have on thereturns that shareholders earn; higher leverage generallyresults in higher, but more volatile returns.

– Fixed costs are costs that do not rise and fall with changes in afirm ’s sales volume. Firms have to pay these fixed costs whether

business conditions are good or bad. – Generally, leverage magnifies both returns and risks.

Capital structure is the mix of long-term debt and equitymaintained by the firm.




Leverage (cont.)

• Operating leverage is concerned with the relationship between the firm ’s sales revenue and its earnings beforeinterest and taxes (EBIT) or operating profits.

• Financial leverage is concerned with the relationship between the firm ’s EBIT and its common stock earnings per share (EPS)

• Total leverage is the combined effect of operating and

financial leverage. It is concerned with the relationship between the firm ’s sales revenue and EPS.




Leverage: Breakeven Analysis

• Breakeven analysis is used to indicate the level of operationsnecessary to cover all costs and to evaluate the profitabilityassociated with various levels of sales; also called cost-volume-

profit analysis.

• The operating breakeven point is the level of sales necessary tocover all operating costs; the point at which EBIT = $0. – The first step in finding the operating breakeven point is to divide the cost of

goods sold and operating expenses into fixed or variable operating costs.

– Fixed costs are costs that the firm must pay in a given period regardless of thesales volume achieved during that period.

– Variable costs vary directly with sales volume.




Leverage: Breakeven Analysis

Using an algebraic calculation as a formula for earnings before interest and taxes yields:

EBIT = ( P Q) – FC – (VC Q)

Simplifying yields:

EBIT = Q ( P – VC ) – FC

Setting EBIT equal to $0 and solving for Q (the firm ’s breakeven point) yields:


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Leverage: Breakeven Analysis(cont.)

Assume that Cheryl ’s Posters, a small poster retailer,has fixed operating costs of $2,500. Its sale price is$10 per poster, and its variable operating cost is $5

per poster. What is the firm ’s breakeven point?



QUANTITY PRODUCED AND SOLD1.00 2,00 3,00 4,00 5,00 6,00 7,00

Total RevenuesProfits

Fixed Costs

Variable CostsLosses

R E V E

N U E S A N D

C O S T S

( $ t h o u s a n

d s

)

175

250

100

50

Total Costs

Break-Even Chart



Leverage: Operating Leverage(cont.)

The degree of operating leverage (DOL) is thenumerical measure of the firm ’s operating leverage.

As long as DOL is greater than 1, there is operatingleverage.



Leverage: Operating Leverage(cont.)

A more direct formula for calculating the degree ofoperating leverage at a base sales level, Q , is the following:

Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500into the above equation yields the following result:



Leverage: Financial Leverage

Financial leverage is the use of fixed financial coststo magnify the effects of changes in earnings beforeinterest and taxes on the firm ’s earnings per share.

The most common fixed financial costs is interest (I)on debt and.



Deg ree o f Financ ial L ev erage(DFL)

DFL S dollarsof sales

=EBIT EBIT - I

DFL Q unitsQ (P – VC)-FC

Q (P – VC)- FC- I=

Degree of Financial Leverage – Thepercentage change in a firm’s earnings per

share (EPS) resulting from a 1 percent

change in operating profit.



• Basket Wonders has $1 million in newfinancing of either: – All Common Stock.

– All debt with a coupon rate of 10%• Expected EBIT= $500,000• What is the DFL for Each of the

Financing Ch oices?



DFL $500,000

Calculating the DFL for NEW equity * alternative

= $500,000$500,000 – 0

* The calculation is based on the expected EBIT

= 1.00

What is the DFL for Each ofthe Financing Ch oices?



DFL $500,000

Calculating the DFL for NEW equity * alternative

= $500,000$500,000 – 0


= 1.00

What is the DFL for Each ofthe Financing Ch oices?



DFL $500,000

Calculating the DFL for NEW debt * alternative

= $500,000{ $500,000 – 100,000}


= $500,000 / $400,0001.25=

What is the DFL for Each ofthe Financing Choices?



– Debt financing will lead to the greatestvariability in earnings per share based onthe DFL.

– This is due to the tax deductibility ofinterest on debt financing.

DFLEquity = 1.00

DFLDebt = 1.25

Which financingmethod will have the

greatest relativevariability in EPS?

Variability of EPS




The firm’s Capital Structure:Types of Capital (cont.)

• The cost of debt is lower than the cost of other forms offinancing.

• Lenders demand relatively lower returns because they take the

least risk of any contributors of long-term capital.• Lenders have a higher priority of claim against any earnings or

assets available for payment, and they can exert far greater legal pressure against the company to make payment than can owners

of preferred or common stock.• The tax deductibility of interest payments also lowers the debt

cost to the firm substantially.




The firm’s Capital Structure:Types of Capital (cont.)

• Unlike debt capital, which the firm must eventually repay, equitycapital remains invested in the firm indefinitely —it has no maturitydate.

• The two basic sources of equity capital are (1) preferred stock and(2) common stock equity, which includes common stock andretained earnings.

• Common stock is typically the most expensive form of equity,followed by retained earnings and then preferred stock.

• Whether the firm borrows very little or a great deal, it is always truethat the claims of common stockholders are riskier than those oflenders, so the cost of equity always exceeds the cost of debt.




The firm’s Capital Structure:Capital Structure (cont.)

Many researchers have examined the the relationship between capitalstructure and the firm ’s value.

– The result is a theoretical optimal capital structure based on balancing the benefits and costs of debt financing.

– The major benefit of debt financing is the tax shield, which allows interest payments to be deducted when calculating taxable income.

– However, an increase in the total cost of debt financing may result from (1)the increased probability of bankruptcy caused by higher debt obligations, (2)

the agency costs of the lender ’s constraining the firm ’s actions, and (3) thecosts associated with managers having more information about the firm ’s prospects than do investors.



Calculate EPS at a given financingstructure.

EBIT-EPS Break-Even Analysis – Analysis ofthe effect of financing alternatives on earnings

per share. The break-even point is the EBITlevel where EPS is the same for two (or more)

alternatives.

Net profitNumber of Common Shares

EPS =

EBIT-EPS Break-Even,or Indifference, Analysis



• Current common equity shares = 50,000 • $1 million in new financing of either: – All Common Stock. sold at $20/share

(50,000 shares) – All debt with a coupon rate of 10%

• Expected EBIT= $500,000• or Expected EBIT = 150,000

• Income tax rate is 30%

Basket Wonders has $2 million in LTfinancing (100% common stock equity).

EBIT-EPS Chart



EBIT $500,000 $150,000*Interest 0 0EBT $500,000 $150,000Taxes (30% x EBT) 150,000 45,000

Net profit $350,000 $105,000 Number of Shares 100,000 100,000

EPS $3.50 $1.05

Common Stock Equity Alternative

EBIT-EPS Calculation withNew Equity Financing



EBIT $500,000 $150,000*Interest(I) 100,000 100,000EBT $400,000 $ 50,000Taxes (30% x EBT) 120,000 15,000Net Profit $280,000 $ 35,000 Number of Shares 50,000 50,000EPS $5.60 $0.70

Long-term Debt Alternative

EBIT-EPS Calculationwith New Debt Financing



0 100 200 300 400 500 600 700

EBIT ($ thousands)

E a r n

i n g s p e r

S h a r e

( $ )

0

1

2

3

4

5

6

Common

Debt

Indifference pointbetween debt and

common stock financing

EBIT-EPS Chart



100 200 300 400 500 600 700

EBIT ($ thousands)

E a r n

i n g s p e r

S h a r e

( $ )

0

1

2

3

4

5

6

Common

Debt

Lower risk. Only a small

probability that EPS willbe less if the debtalternative is chosen.

P r o

b a

b i l i t y of

O c c ur r en

c e

( f or

t h e pr o b

a b i l i t y

d i

s t r i b u t i on

)

What About Risk?



100 200 300 400 500 600 700

EBIT ($ thousands)

E a r n

i n g s p e r

S h a r e

( $ )

0

1

2

3

4

5

6

Common

Debt

Higher risk . A much larger

probability that EPS willbe less if the debtalternative is chosen.

P r o

b a b i l i t y

of

O c c u

r r en

c e

( f or

t h e pr

o b a b i l i t y

d i s

t r i b u t i on

)

What About Risk?



12-29



12-30

Ks(2)



12-31

The firm’s Capital Structure:



12-32




12-33


P 0 = D1 / (Ks- g)



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Chapter Summary

• Leverage results from the use of fixed costs to magnify returns to a firm’s owners.Capital structure, the firm’s mix of long -term debt and equity, affects leverage andtherefore the firm’s value. Breakeven analysis measures the level of sales necessary tocover total operating costs. The operating breakeven point increases with increased fixedand variable operating costs and decreases with an increase in sale price, and vice versa.

• Operating leverage is the use of fixed operating costs by the firm to magnify the effectsof changes in sales on EBIT. The higher the fixed operating costs, the greater theoperating leverage. Financial leverage is the use of fixed financial costs by the firm tomagnify the effects of changes in EBIT on EPS. The higher the fixed financial costs, thegreater the financial leverage. The total leverage of the firm is the use of total fixedcosts — both operating and financial — to magnify the effects of changes in sales on EPS.

• Debt capital and equity capital make up a firm’s capital structure . Capital structurecan be externally assessed by using financial ratios — debt ratio, times interest earnedratio, and fixed-payment coverage ratio. The major benefit of debt financing is the taxshield. However, an increase in the cost of debt financing may due to the increased

probability of bankruptcy, agency costs imposed by lenders, and asymmetricinformation.

Capital Structure Decisions 8

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