Ch 14 Capital Structure Management

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Copyright 2003 South-Western/Thomson Learning

Chapter 14Capital Structure Management

in Practice


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Introduction

This chapter focuses on the impact ofleverage on corporate profits. We willcover:

Operating and financial leverage (pp.472-475)

Breakeven analysis (Appendix 14A)

EBIT-EPS analysis (pp. 482-493)


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Operating and Financial Leverage

Based on fixed operatingand/or fixedcapital costs:

Fixed operating costsassets added to

grow the firm Depreciation of PP&E

Rent and utility costs

Property taxes

Salaried costs

Fixed capital costfunds the assets

Interest charges

Preferred dividends


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Operating and Financial Leverage

Operating Leverage Results from fixed operating costs such that a

change in sales revenue is magnified into arelatively large change in EBIT

Financial Leverage Results from fixed capital costs such that achange in EBIT is magnified into a relativelylarge change in EPS

Benefits of leverage occur only withinspecific range of volumes until the firmneeds to commit additional fixed operatingor capital costs

See Table 14.2, p.475


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Breakeven Analysis (Appendix 14A,p. 505)

Also called cost-volume-profitanalysis

Describes relationship among firms

sales, fixed cost (FC), variable costs(VC), and EBIT/EPS at various unitoutput levels (Q)

Main objective: at what sales level (Q)does the firm break even?


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Graphical Breakeven Analysis

Graph both revenue and cost in $ on yaxis versus output (Q) in units on x axis:

Graph Total Revenue (TR = Q x

Price/unit) beginning at origin

Graph Total Cost (FC + VC) beginningwith FC on y axis

Breakeven is where TR and TC crossTR = TC

See Fig. 14A.1, p. 506


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Algebraic Breakeven Analysis

Total Revenue (TR) = Total Cost (TC) TR = VC + FC

TR = VC/unit x units + FC

Sales/unit x units = VC/unit x units + FC Sales/unit x unitsVC/unit x units = FC

(Sales/unitVC/unit) units = FC

Note: Sales/unitVC/unit = Price-VC/unit =contribution margin ( econ. profit)/unit

Therefore:

B.E units (Q) = FC/contrib. margin/unit


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Example: Allegan Mfg. Co

FC = $1 mils, Price (P) = $250, VC/unit =$150

Qb= $1 mils/$250$150 = 10,000units

Incr. P by $25Qb = $ 1 mils/$275 - $150 = 8000units

Spend CapEx of $1 mils ($100,000/yr in

depreciation) to reduce VC/unit by $25Qb= $1.1 mils/$250 - $125 = 8800units

Ex: pp. 507-509 (same example in detail)


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Other Applications

1. Analyzing effects of other variables, e.g.,price (prior slide)

2. Breakeven in terms of $ sales (p. 507)Sb = FC/ 1- (VC/P)

3. Breakeven in terms of EBT or EPS (add Int.to FC = fixed charges)

4. Target Volume (p. 507)Qt= (FC + Target Profit)/Contribution

Margin/unit5. Cash breakeven (p. 512-513)

Qc= (FCDepr.)/Contri. Margin/unitNote: Useful for homework #7


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Use EBIT-EPS analysis for determiningdebt versus equity financing for individualprojects

But, should maintain target capital structure

Steps Develop economic/profit scenarios Begin with Earnings before Interest and Taxes

(EBIT) and calculate Earnings Per Share (EPS)for both alternatives

Best alternative has highest earnings per share Other considerations: flexibility, dilution of

ownership/earnings, use of cash

See Ex, p. 482

EBIT-EPS Analysis


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EBIT-EPS Analysis Breakeven

More accurate method of determining when tooffer equity or debtcalculate indifferencepoint

Determine the level of EBIT where EPS wouldbe identical under either debt or equityfinancing: EPS (debt fin.)=EPS (equity fin.), or

Debt financing Equity financing

=Ne

(EBITIe) (1T)Dp

Nd

(EBITId) (1 - T)Dp

See Ex. p. 484


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Graphical Analysis of EBIT - EPS

EPS

EBIT

Debt Financing

Equity Financing

Indifference Point

Advantage to debtfinancing

Advantage toequity financing


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Analyze the Riskiness of theCapital Structure For Expansion

1. Compute the expected level of EBIT after expansion.

2. Estimate the variability of operating income (Stnd.

Dev.).

3. Compute the indifference point between two financinplans.

4. Estimate the probability that EBIT will exceed the

indifference point (calc. z and use Table V).

5. Examine the market evidence to see if the capitalstructure is too risky in relation to the firms level of

Business risk Industry norms for leverage and coverage ratios Recommendation of the firms investment bankers

Ex:, pp. 485-486


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Warning!

Remember, financial leverage is adouble-edged sword; it enhancesexpected returns but also increases risk

Even if EPS is higher with debt financing,high leverage could result in lower PE,

and lower stock price (bottom p. 486)

Lesson: the market will say whetherborrowing is too risky


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Cash Insolvency Analysis (p. 487)

Helps managers choose their capital structureduring a recession when liquidity is importantCBR= CB0+ FCFR

CB0= cash at beginning of period,

FCFR= free cash flows during recession, andCBR= cash balance during recession (you wanit to be positive)

Firms needs cash (or access to cash) to surviva recession

Therefore, make CB0large enough or have

guaranteed access to bank credit and othersources of cash, e.g., auto company

C id d i C i l


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Factors Considered in CapitalStructure Decisions

Tendency to cluster around industryaverage

Need for funds

Benchmark leverage ratios

By lenders and bond rating agencies

Managerial risk aversion

Retain control


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Homework Problems

In this order: Ch 14: # 20, 14A: # 1 Assignment # 7: For Ford Automotive calculate

the following:

1. Break-even units for EBIT

2. Break-even units for EBT

3. Graph TR and TC vs units showing #2

4. Units required to earn targeted EBT of $5 bils

5. Your realistic plan for #4 involving volume,cost and/or price changes (see Allegan Mfg.)

Next Class: Chapters 16 & 19

Ch 14 Capital Structure Management

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