Drivers of Share Holder Value

8/9/2019 Drivers of Share Holder Value

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Name: Tanay SinhaRoll No. 38Program Name & Batch: PGDM-Financial Markets 2008-2010

Proposed Topic of Research

Drivers of Share Holder Value

Objectives of Proposed Research

Study about the measures of shareholder value.

Analyze how the intrinsic values affect the shareholdervalue.

To identify the key drivers of shareholder value.

To analyze shareholders value across Time, Cross Sectionand Sectors.



Background of Proposed Research

Introduction

Enhancement of shareholder value through value innovations istoday an accepted maxim by the corporate world. Various

approaches have been developed by researchers andpractitioners for planning, measuring and achieving the valuemaximization goal. Various accounting measures like Return onInvestment (ROI), Return on Equity (ROE), Residual Income(RI), Holding Period Return (HPR), Market value Added (MVA),Price Earning (PE), Price to Book (P/B) and so on are used. The

accounting and cash flow based measures are rich and providea comprehensive analysis of how a firm can increaseshareholder value.

In today·s world shareholder value is considered the mostimportant thing because a shareholder invests his money in the

company and he wants risk adjusted return so the organizationmainly focuses on the shareholder value as shareholders arethe owners of the company. It·s the real key to creatingwealth. Drivers that drive shareholder value are reallyimportant in knowing how to increase shareholder value. Thereare four variables that drive shareholder value like i.e. Growth,



Profit, Economic Factors and Non Financial Factors. In thesethere are various factors like sales growth, increase in netmargin, asset turnover, cost of capital, size of company,

sensex, GDP and so on. In a vehicle as it is very important toknow what drives it, in the same way it is also necessary toknow what factors increase or decrease the shareholder value.



Literature Overview Earlier many people have given their views regardingshareholder value, drivers of shareholder value and how toincrease the shareholder value. Some of the renowned personsare:

LaurenceBooth, Professor of Finance, RotmanSchool of Management, University of Toronto

Many corporate executives still focus on quarterly earnings figuresas a key driver of stock market values. Although no-one can discount

the importance of quarterly earnings numbers or the impact on thestock market of earnings surprises, they are not the fundamentaldriver. Stock market values are driven by real corporateperformance, as compared to market benchmarks. The keyrelationship is whether the money entrusted to corporatemanagement earns a higher return than the owners can getelsewhere.

Max J. Pucher, Founder and Current Chief Architect of ISIS Papyrus Software.

Shareholder value and competition do have a relationship that isnot as direct as one might think because it involves human



perceptions. The entity of a business and the even more abstractentity of shareholder value are illusions that have no counterpart in

reality. Therefore it is the human illusion of perceived value thatdrives competition in economy and naturally the same applies toshareholder value.

Economic Value Added

In corporate finance, Economic Value Added or EVA is anestimate of economic profit, which can be determined, among

other ways, by making corrective adjustmentsto GAAP accounting, including deducting the opportunity costof equity capital. The concept of EVA is in a sense nothingmore than the traditional, commonsense idea of "profit,"however, the utility of having a separate and more preciselydefined term such as EVA or Residual Cash Flow is that it

makes a clear separation from dubious accounting adjustmentsthat have enabled businesses such as Enron to report profitswhile in fact being in the final approach to becoming insolvent.EVA can be measured as Net Operating Profit after Taxes(or NOPAT ) less the money cost of capital. EVA is similar toResidual Income (RI); although under some definitions there

may be minor technical differences between EVA and RI (forexample, adjustments that might be made to NOPAT before itis suitable for the formula below). Another, much older termfor economic value added is Residual Cash Flow. In all threecases, money cost of capital refers to the amount of moneyrather than the proportional cost (% cost of capital). The



amortization of goodwill or capitalization of brand advertisingand other similar adjustments are the translations that can bemade to Economic Profit to make it EVA. The EVA is a

registered trademark by its developer, Stern Stewart & Co.

Economic Value Added (EVA), or economic rent, is a widelyrecognized tool that is used to measure the efficiency withwhich a company has used its resources. In other words, EVA is the difference between return achieved on resources

invested and the cost of resources. Higher the EVA, betterthe level of resource unitization.

In the field of corporate finance, Economic Value Added is away to determine the value created, above the requiredreturn, for the shareholders of a company.

The basic formula is:

where

, called the Return on Invested Capital (ROIC).

r is the firm's return on capital, NOPAT is the Net OperatingProfit After Tax, c is the Weighted Average Cost of



Capital (WACC) and K is capital employed. To put it simply, EVA is the profit earned by the firm less the cost of financing thefirm's capital.

Shareholders of the company will receive a positive valueadded when the return from the capital employed in thebusiness operations is greater than the cost of that capital; see Working capital management. Any value obtained byemployees of the company or by product users is not includedin the calculations.

Things to Note a bout EVA

EVA is a measure of dollar surplus value, not the percentagedifference in returns. It is closest in both theory andconstruct to the net present value of a project in capitalbudgeting, as opposed to the IRR. The value of a firm, in DCFterms, can be written in terms of the EVA of projects in placeand the present value of the EVA of future projects.

DCF Value and NPV

Value of Firm = Value of Assets in Place + Value of FutureGrowth = (Investment in Existing Assets + NPV Assets inPlace) + NPV of all future projects

= ( I + NPV Assets in Place) +



Where there are expected to be N projects yielding surplusvalue (or excess returns) in the future and I is the capital

invested in assets in place (which might or might not be equalto the book value of these assets).

The Basics of NPV

NPV = : Life of the project is n years

Initial Investment =:

Alternative Investment NPV

=

=

NPV to EVA (Continued)

Define ROC = EBIT (1-t) / Initial Investment: The earningsbefore interest and taxes are assumed to measure true

earnings on the project and should not be contaminated bycapital charges (such as leases) or expenditures whosebenefits accrue to future projects (such as R & D).

Assume that : The present value of



depreciation covers the present value of capital invested, i.e,it is a return of capital.

DCF Valuation, NPV and EVA

Value of Firm = ( I + NPV Assets in Place) +

=

=

=

In other words,Firm Value = Capital Invested in Assets in Place + PV of EVA from Assets in Place + Sum of PV of EVA from new projects

A Simple Illustration

Assume that you have a firm withIA = 100 In each year 1-5, assume that

ROCA = 15% I = 10 (Investments are at beginning of each year)

WACCA = 10% ROC New Projects = 15%



WACC = 10%

Assume that all of these projects will have infinite lives.

After year 5, assume that

Investments will grow at 5% a year foreverROC on projects will be equal to the cost of capital (10%)

Firm Value using EVA ApproachCapital Invested in Assets in Place = $ 100EVA from Assets in Place = (.15 - .10) (100)/.10 = $ 50+ PV of EVA from New Investments in Year 1 = [(.15 - .10)(10)/.10]= $ 5+ PV of EVA from New Investments in Year 2 = [(.15 -.10)(10)/.10]/1.12 = $ 4.55

+ PV of EVA from New Investments in Year 3 = [(.15 -.10)(10)/.10]/1.13= $ 4.13+ PV of EVA from New Investments in Year 4 = [(.15 -.10)(10)/.10]/1.14 = $ 3.76+ PV of EVA from New Investments in Year 5 = [(.15 -.10)(10)/.10]/1.15 = $ 3.42

Value of Firm = $ 170.86



In Practice: Some Measurement Issues

How do you measure the capital invested in assets in place?

Many firms use the book value of capital invested as theirmeasure of capital invested. To the degree that book valuereflects accounting choices made over time, this may not betrue.

In cases where firms alter their capital invested through theiroperating decisions (for example, by using operating leases),the capital and the after-tax operating income have to beadjusted to reflect true capital invested.

How do you measure return on capital?

Again, the accounting definition of return on capital may notreflect the economic return on capital.

In particular, the operating income has to be cleansed of any



expenses which are really capital expenses (in the sense thatthey create future value). One example would be R& D. Theoperating income also has to be cleansed of any cosmetic or

temporary effects.

How do you estimate cost of capital?

DCF valuation assumes that cost of capital is calculated usingmarket values of debt and equity. If it assumed that bothassets in place and future growth are financed using themarket value mix, the EVA should also be calculated using themarket value.If instead, the entire debt is assumed to be carried by assets

in place, the book value debt ratio will be used to calculatecost of capital.Implicit then is the assumption that as the firm grows, itsdebt ratio will approach its book value debt ratio.

Year-by-year EVA Changes

Firms are often evaluated based upon year-to-year changes inEVA rather than the present value of EVA over time.The advantage of this comparison is that it is simple and doesnot require the making of forecasts about future earningspotential.



Another advantage is that it can be broken down by any unit -person, division etc., as long as one is willing to assign capitaland allocate earnings across these same units.

While it is simpler than DCF valuation, using year-by-year EVA changes comes at a cost. In particular, it is entirely possible

that a firm which focuses on increasing EVA on a year-to-yearbasis may end up being less valuable.Year-to-Year EVA Changes

0 1 2 3 4EBIT (1-t) $ 15.00 $ 16.50 $ 18.00 $ 19.50 $ 21WACC (Capital) $ 10.00 $ 11.00 $ 12.00 $ 13.00 $ 14

EVA $ 5.00 $ 5.50 $ 6.00 $ 6.50 $ 7.00PV of EVA $ 5.00 $ 4.96 $ 4.88 $ 4.78Terminal Value ofEVA $ 75.0Value: Assets inPlace = $ 100.00PV of EVA = $ 70.85

Value of Firm = $ 170.85

When Increasing EVA on year-to-year basis may result inlower Firm Value.

If the increase in EVA on a year-to-year basis has been



accomplished at the expense of the EVA of future projects. Inthis case, the gain from the EVA in the current year may bemore than offset by the present value of the loss of EVA from

the future periods.

For example, in the example above assume that the return oncapital on year 1 projects increases to 17%, while the cost ofcapital on these projects stays at 10%. If this increase invalue does not affect the EVA on future projects, the value of

the firm will increase.If, however, this increase in EVA in year 1 is accomplished byreducing the return on capital on future projects to 14%, thefirm value will actually decrease.

Firm Value and EVA Tradeoffs over Time

0 1 2 3 4Return on Capital 15% 17% 14% 14% 14%Cost of Capital 10% 10% 10% 10% 10%EBIT(1-t) $ 15.00 $ 16.70 $ 18.10 $ 19.50 $20.9WACC(Capital) $ 10.00 $ 11.00 $ 12.00 $ 13.00 $14EVA $ 5.00 $ 5.70 $ 6.10 $ 6.50 $ 6.9PV of EVA $ 5.18 $ 5.04 $ 4.88 $ 4.71

Terminal Value ofEVA $73Value: Assets inPlace = $ 100.00PV of EVA = $ 69.68Value of Firm = $ 169.68



EVA and RiskWhen the increase in EVA is accompanied by an increase in thecost of capital, either because of higher operational risk orchanges in financial leverage, the firm value may decrease evenas EVA increases.

For instance, in the example above, assume that the spread

stays at 5% on all future projects but the cost of capitalincreases to 11% for these projects. The value of the firm willdrop.

SUMMARY OF EVA

EVA is a method to measure a company´s trueprofitability and to steer the company correctly from theviewpoint of shareholders



EVA helps the operating people to see how they caninfluence the true profitability (especially if EVA isbroken down into parts than can be influenced)

Clarifies considerably the concept of profitability (theformer operating profit/capital (ROI %) -observation isturned into EVA (FIM, $, £) -observation)

EVA improves profitability usually through the improved

capital turnover

Companies have usually done a lot in cutting costs butthere is still much to do in improving the use of capital

EVA is at its best integrated in incentive systems



MARK ET VA LU E A DDED Market Value Added (MVA) is the difference between thecurrent market value of a firm and the capital contributed byinvestors. If MVA is positive, the firm has added value. If it isnegative, the firm has destroyed value. The amount of valueadded needs to be greater than the firm's investors couldhave achieved investing in the market portfolio, adjusted forthe leverage (beta coefficient) of the firm relative to themarket.

The formula for MVA is:

where:

MVA is market value added

V is the market value of the firm, including the value ofthe firm's equity and debt

K is the capital invested in the firm



MVA is the present value of a series of EVA values. MVA iseconomically equivalent to the traditional NPV measure ofworth for evaluating an after-tax cash flow profile of a

project if the cost of capital is used for discounting.

A calculation that shows the difference between the marketvalue of a company and the capital contributed by investors(both bondholders and shareholders). In other words, it is the

sum of all capital claims held against the company plus themarket value of debt and equity.

Calculated as:

Market Value Added (MVA) is the difference between theequity market valuation of a listed/quoted company and thesum of the adjusted book value of debt and equity invested inthe company. In other words: it is the sum of all capital claimsheld against the company; the market value of debt and the

market value of equity.

CA LCU L ATI ON OF MARK ET VA LU E A DDED.F O RMU L A



Market Value Added (MVA) = Market Value - Invested Capital.

The higher the Market Value Added (MVA) is, the better it is.

A high MVA indicates the company has created substantialwealth for the shareholders. MVA is equivalent to the presentvalue of all future expected EVAs. Negative MVA means thatthe value of the actions and investments of management is lessthan the value of the capital contributed to the company bythe capital markets. This means that wealth or value has been

destroyed.

The aim of a firm should be to maximize MVA. The aim shouldnot be to maximize the value of the firm, since this can beeasily accomplished by investing ever-increasing amounts ofcapital.

LIMITATI ONS OF MARK ET VA LU E A DDED

1. MVA does not take into account the opportunity costs ofthe invested capital.2. MVA does not take into account the interim cash returnsto shareholders.



3. Market Value Added (MVA) cannot be calculated atdivisional (Strategic Business Unit) level and cannot be usedfor private held companies.

RO E (Return on Eq uity)

Return on equity ROE is a version of ROI. The logical next stepis to eliminate debt altogether, and define investment asequity. ROI then becomes ROE. One must be careful to takethe amount of equity from the balance sheet that correspondsto the amount of net profit after tax that is available to

equity owners. One may have to include in equity all stock,common and preferred, as well as all classes, A and B, if thereare classes. But, normally, only common stock equity CS isincluded (because it is relevant and important to commonshareholders). This implies that preferred shares, as well asminority interests must not be present in equity. This also



means that preferred stock dividends DPS and the minorityinterests' share of income MI must have been deducted fromprofit after tax. The return on equity ROE is given by

ROE = (PAT-DPS-MI) / CS

This ratio gives the rate of return earned by equity owners inthe current year. It is one of the most commonly used ratios.In this format it is correctly linking the net after tax earningswhich will accrue to owners in the form of dividends or

retained earnings. One will recall from the previous sectionthat averaging of the denominator is recommended, but it isnot always done in order not to lose historical information.

There are a few more modifications that can be found incertain circumstances. One is to exclude from equity,

intangible assets which were previously mentioned as no longer(or not yet) contributing to profit generation. The investmentconcept used is then net worth (i.e. total assets minus all debt,which naturally equals equity), and the deduction of intangiblesleaves tangible net worth TNW in the denominator. The ratiois return on tangible net worth ROTNW.

ROTNW = PAT / TNW

Another (more common) modification of ROE is to defineinvestment as market value of equity (i.e. total marketcapitalization), calculated as current common stock price Pmultiplied by the number of shares outstanding N. The stock



price P is the closing price on the day of the end of the fiscal year of the company. The number of shares outstanding N isgiven in the financial statements or can be calculated by

subtracting the number of shares held as treasury stock fromthe number of shares authorized and issued. The return onmarket capitalization ROMC is given by

ROMC = PAT / (P * N)

Once again, it is appropriate to average the total market

capitalization to reflect the changing equity funds entitled toshare in the profits. The averaging is based on the number ofdays a given number of shares is outstanding. Each givennumber of shares is multiplied by the average price over theperiod. Although, mathematically desirable, this modification israrely done, except when the equity has changed drastically

such as in the case of large new stock flotation andinformation of outstanding common stock is present in theannual report.



MARGIN GROWTH

The gross profit is the difference between the sales revenueand cost of goods sold. Gross profit margin GPM is stated as apercentage of dividing gross profit by revenue from sales.

GPM = (Sales revenue - cost of goods sold)/ Sales revenue

Profit margin is the end result of unit cost and volumestrategies, discussed above, as well as pricing strategy.

How prices are determined varies from industry to industryand among firms. One very common form of pricing is the cost-plus method in which the cost is incremented by somepercentage (sometimes known as mark-up) or dollar amount. In



this method, the price is the by-product of a profit marginstrategy which is, in turn, guided by the need to coveroverhead, taxes and return to owners. There are many

variations of the cost-plus method of pricing. In manypractical circumstances, managers entering a particular marketfor the first time find it most reasonable to use the profitmargin of competitors as an appropriate return for the firm.For instance, in retailing, the mark up in different stores issimilar. This is often dictated by competition: stores that

would overprice by even a few pennies items availableeverywhere, will see their sales tumble. This also means thatthe technology leader sets the highest price. As indicatedearlier, other firms use pricing strategies that align their ownprices proportionately under that of the technology leader.

When cost-plus method of pricing is used, there are dangerswhich the analyst must assess. First, cost-plus pricing does notencourage efficiency of production since the costs are simplypassed on to consumers. Second, pricing of products can besub-optimal from a market point of view. When a firm pricesits products according to market demand, price shouldcorrelate with quality because, as long as the consumer is wiseenough to judge a product by intrinsic benefits, the betterquality product will be in much greater demand than the lowerquality product at the same price. The firm should learn fromthis message that customers will pay a higher price whenproduct shortages occur. But when the cost-plus method is



used, differences in production costs determine prices, notquality as perceived by the market.

Theoretically, pricing should be based on consumerpreferences. Market research exists for the purpose ofhelping managers to choose optimum marketing and pricingstrategies. Historical data on market reaction to price changesis most useful. But, it can only provide answers on existingsales. When a product is introduced, it may be necessary to

adjust price as experience tells when the product is over orunder priced. Unfortunately, price changes are themselvesdestabilizing for consumers and should be avoided. Marketingexperts teach us to use comparable test markets to gatherempirical information.

Economic theory tells us that total revenue is maximized at

the point where the demand price elasticity is one. Thisresults from the fact that if a price is either increased orreduced, the consequent change in quantity reduces totalrevenue. But firms do not necessarily set total revenue astheir goal (with the exception of the benefit from the learningcurve previously outlined). Instead, one will recall that it is

profit that they seek to maximize at the point where marginalrevenue is equal to margin cost (i.e. one item more or lesswould result in actual or opportunity marginal loss). Theconsequence is that prices, as well as costs, are dependent onvolume.



Naturally, a monopoly will try to price its product at a muchhigher price than a firm in perfect competition. In addition,the monopoly will also try to segment its markets and price

discriminate among different groups of customers, so that theprofit is maximized from each individual sale rather than fromtotal profit. A firm in a monopoly position is clearly moreprofitable than a firm with competitors. However, firms thattake excessive advantage of their customers, such as in thecase of some utilities (e.g. AT&T prior to its break up, or

Microsoft more recently), may find that customer unhappinessleads to governmental anti-trust action.

The analyst must find evidence in the business plan and in theannual report that the firm has given all necessary attentionto customer preferences in order not to over or under pricethe product. After all, the firm exists to serve its customers.It is customers' attitudes and preferences that shoulddetermine price. Yet, the firm must also be answerable to itsemployees that deserve adequate remuneration, and mostimportantly, its owners that expect a return commensuratewith the risk they have assumed. Ant that dictates maximizingprofits.



N ET MARGIN A company's profitability is very often evaluated by comparingearnings to sales rather than to investment. This is done inorder to judge management's strategy with respect toadministrative, general and overhead expenses. This analysis isa major complement to the analysis of gross profit margindiscussed in Chapter 9. Here the net profit margin NPM is

given by dividing net profit after tax PAT by sales

NPM = PAT / Sales

Although this is an important and useful statistic, the ratio isautomatically calculated in a normalized income statement, and



is not given as much recognition as ROA or ROE discussed inprevious sections. But its major purpose is, as previouslystated, to assess overhead costs.

Net profit margin is affected by the inclusion ofextraordinary items. To avoid this distortion, it is preferableto look at operating profit or earnings before interest andtaxes (EBIT ), which is also before extraordinary items. Themost reliable statistic is therefore the net operating profit

margin which is given byNOPM = EBIT / Sales

INT E R EST Interest expense was analyzed from the stand point ofdetermining if the firm will be able to borrow in the future.Here the concern is whether the interest expense is in linewith management strategy. If for instance, an expansion is

planned, this means that new financing is needed, and asoutlined in the previous chapter, the financing can be fromdebt (or preferred stock) at first. Since inventory and assetexpansion precede sales, interest increase must also precedesales. If interest expense decreases instead, one must lookfor an explanation (may be preferred stock was issued); and if



no explanation is apparent, then the inability or unwillingnesson the part of management to use financial leverage must bequestioned.

TAX ESTaxes are found in different places in the income statement.When comparing companies in different countries, taxes arethe least comparable items of the income statement. For mostcountries the largest tax on businesses is the income taxcalculated on net profit before tax. The corporate income taxrate varies from as little as 10% (in Switzerland) to well over50% (for Scandinavian countries). In the United States thecorporate income tax rate is a moderate 34% at the Federallevel, but with State corporate income taxes, the overalleffective rate can almost reach 50%. For European companies(as well as companies in several other countries), the valueadded tax (VAT ) is the most important tax, and it is generallycalculated at a rate of around 20% on total sales net of VAT paid on purchases. There are also real estate taxes, salestaxes, customs and excises, which are usually lumped as a small

amount in general and administrative expenses. Some countriesalso assess a gross receipt tax calculated (as the wordingimplies) on gross sales; the tax is in addition or instead of thecorporate income tax.



The corporate income tax reported in the income statement isnot the actual tax paid. The actual tax liability is calculated onthe income tax return with all tax rules on income recognition

and allowable deductions that are permitted and mostadvantageous to the firm. The reason why the actual tax is notthe one shown on the income statement, is attributable to theaccounting requirement of matching expenses with revenues:the tax on the income statement is calculated using theofficial tax rate for the income and expenses as they are

shown in the income statement, rather than as they appear inthe tax return. For instance, an accelerate depreciation isallowed on the tax return, but straight line is used on theincome statement: this reduces tax liability today, and theresulting reduction in tax is the deferred income tax liabilitywhich has been mentioned on several occasions. Another

example is that of employee post-retirement benefits whichare expensed, recorded as liability, but not actually paid out(until the employee retires), and therefore, not deductible fortax purposes: this creates a deferred income tax asset forthe amount of tax that will not have to be paid when the post-retirement payments are deductible for tax purposes. Other

examples of deferred income tax assets are loss carryforwardand unused investment tax credit. American companies mustexplain in notes to financial statements and/or statements, a) the current, deferred and expensed income tax (i.e. incomestatement amount), b) a reconciliation of the effective taxrate with the statutory federal income tax rate, and c) a list



of sources of temporary and permanent deferred taxliabilities and assets. Studying this information can be usefulfor the analyst to uncover unusual items.

The tax information in the note to financial statements alsoought to be a tool for analyzing if the company follows a taxsaving policy, but in reality, such analysis is extremely difficultto do because details of the corporate income tax return areonly for the eyes of top management and auditors.

TURN OV E R AN D EFFICI ENCYThere are generally three lines of inquiry pertaining to fixedassets: turnover, rate of return and relative size. Each may

reveal some problem. But, given the gross distortion that onecan expect in the accounting numbers, as just discussed above,not much significance should be placed on the first two. A fourth approach is based on the income statement expenses toevaluate management care for their fixed assets.



1) E fficiency:

To verify that the firm does not use excessive amounts offixed assets to conduct its business, a fixed assets turnoverratio FAT is calculated

FAT = Sales / Fixed assets

This ratio is compared over several years and with othercompanies in the industry. Likewise, the total assets turnoverratio T AT should confirm the assessment of efficiency withFAT ratio; if it doesn't, then one should look into the size ofintangible assets and the level of current assets.

T AT = Sales / Total assets

This approach is often conducted in the context of the DuPontbreak out [or in the context of the pyramid of coefficients, asit is known in Russia].A low ratio compared to prior years andother firms in the industry may be indicative of inefficiency(i.e. the company may have assets that are fully utilized). A high ratio compared to industry or prior years may beindicative of excessive use of assets that may result in

breakdowns.

Let us first calculate Timken Total Assets Turnover ratio for1999. The total assets of Timken Company in 1999 were $



2,441.3 million, and sales for 1999 of The Timken Company -were $ 2,495 millions. T AT ratio is, therefore

T AT = 2,485 / 2,441.3 = 1.02The T AT of the Timken Company in 1998 was 1.09. If wecompare these T AT values to industry statistics we find thatTimken's T AT ratio is somewhat lower than the lower quartilevalues for the different industries to which Timken belongs.

Now, let us calculate Timken Fixed Assets Turnover ratio for1999. The fixed assets in 1999 were $ 1,381.5 million, and thesales for 1999 were $ 2,495 million. FAT ratio is

FAT = 2,485 / 1,381.5 =1.81

This ratio in 1998 was 1.99. Timken's FAT ratio is also lower

than the lower quartile of comparable industries.

R ETURN ON ASS ETS (RO A)

Return on assets will be extensively analyzed in for its impacton profitability. Furthermore, it is analyzed for an assessmentof the adequacy of fixed assets. Return on assets can becalculated for fixed assets only ROFA or for total assetsROT A:



ROFA = Net after tax profit / Fixed assets

ROT A = Net after tax profit / Total assets

Return on assets is somewhat more informative than assetturnover because it incorporates expenses. A firm that hashigher expenses, and thus a lower return on assets, can begenerally considered less efficient.

Let us take Delta Air Lines as an example for the calculationof these ratios. To calculate return on total assets, we take1999 net profit after tax of $ 1,101 million from Delta AirLines Income Statement, and 1999 total assets of $ 16,544million from Delta Air Lines Balance Sheets. This gives a ROFA of

ROFA = 1,101 / 16,544 = 0.07 or 7%

To judge Delta's performance we compare to ROFA ratios ofother air carriers. AMR Corporation (i.e. American Airlines) had net earnings of $ 1,314 million in 1998 on total assets of $22,303 million for a ROFA of 0.06. UAL ROFA was also 0.06

(i.e. 1,235 / 20,963) in 1998. US Airways had a ROFA of 0.07(i.e. 538 / 7,870). Comparing now to foreign air carriers: KLMhad a 1998 ROFA of 0.03 (207/6300), and so did Air Canada(152 / 6,422). This indicates that Delta Air Lines slightlyoutperformed its domestic competitors, and did much betterthan its foreign competitors.



For a more complete picture, it is necessary to compareDelta's ROFA to the entire industry. To do that we must usethe RMA format this is built with profits before tax instead

of profit after tax. Delta's profit before tax in 1999 was $1,826. This gives a ratio of profit before tax/total assets of

PBT/T A = 1,826 / 16,544 = 0.11 or 11%

The median RMA ratio for Profit before tax/Total assets forair transportation was only 2.5% and the highest quartile 9.2%

for the entire industry. This shows that Delta had a very good year in 1999. Yet, there were many comparable firms that dideven better: among the very large air carriers included in RMA statistics (i.e. 17 firms with sales in excess of $ 25 millions) 25% had profit before tax/total assets exceeding 16.6%.

COMPARING SIZ E OF FIX ED ASS ETS

AN D SIZ E OF EQUITYA firm would be forced out of business if it had to liquidatefixed assets in order to repay debts. This implies that fixedassets must be financed with permanent capital: long termdebt or equity. To verify that this is so, one can look at a



common-size balance sheet and verify that the fixed assetsrepresent a smaller proportion of total assets than theproportion of the total of long term debt plus equity in the

balance sheet. This inquiry is a mirror image of the net workingcapital analysis, which also demands that a portion of currentassets be financed by permanent capital (i.e. not currentliabilities).

The proportion of fixed assets in total assets can also be

compared between companies. If a company has a significantlysmaller proportion of fixed asset to total asset, one wouldnormally conclude that the firm is more efficient than theothers. This could, however, be indicative that a company hasan insufficient proportion of fixed assets to conduct itsoperations, or maybe the assets are old and fully depreciated.On the contrary, if, in conjunction with other ratios, it isshown that the company has too much capital tied up in fixedassets, one would conclude that the firm is inefficient.Remembering the likely distortions in these numbers, it wouldbe strongly recommended that questions be asked ofmanagement, if at all possible, rather than relying of balancesheet numbers alone.

INCOM E STAT EM ENT EXP ENS ES US ED T O ASS ESSB A L ANC E SH EET FIX EDASS ETS



The indirect approach to studying management's strategypertaining to fixed assets can be much better than looking atthe fixed assets amounts themselves. First in line is a

maintenance and repair expense. From a production manager'spoint of view, such expenses must be considered mandatory.Note that because they are stated in current monetary units,they are not distorted by inflation the way fixed assets anddepreciation are. Expense data is therefore reliable. If thesemaintenance and repair expenses increase at a faster rate

than all other items of the income statement and balancesheet, or if they are much larger than in other companies ofthe industry, there can be some problem. The problem can bethat the equipment is getting too old, and its constant repair isexpensive. In such a case, management must be asked why theequipment is not replaced in a timely fashion or with better

quality equipment. When clients are not served because ofequipment failures, sales are lost. (Remember, sales must notbe missed!)

If, on the contrary, maintenance and repair expense drops offin the current year, or if it is much smaller than in othercompanies in the industry, then a different problem issuggested. The company may try to save on this expense inorder to boost its profit image. It should be obvious thatskimping on maintenance is counterproductive: equipment willdeteriorate faster in the future. However, fewer repairs canalso be the result of better equipment.



O P E RATING LEV E RAG E There are many styles of management and many types ofsuccessful marketing strategies. Each is the result of acontinuous adjustment to market, to customers and to



competitors. All companies would prefer to charge a high priceand achieve a large sales volume. In most cases, competitionwill, on the contrary, either impose lower prices for large

volume, or force a company to seek a niche with a high pricedproduct supported by services for a select clientele in arestricted market, in other words, a small volume. The choiceof a large volume (which allows lower cost and thereforeprices) usually requires an increase in automation and fixedcost. Variable costs, which consist mostly of direct salaries,

are expensive compared with overhead unit cost allocated overa large volume. Thus, the benefit of operating leverage whichstems from using large fixed assets to automate and toproduce a larger quantity at lower unit cost.

INCR E ASING PROFIT MARGINSFROM ST E A DY SA LES

In Graph G-10.1 below, a break-even type graph is representingtwo levels of operating leverage. A choice is proposed between

operating either with fixed cost FC1, variable cost VF1, andcontribution margin P - VC1, or with higher fixed cost FC2,smaller unit variable VC2, and larger contribution margin P -VC2, while total revenue TR remains the same.

Graph G-10.1



Graph T-10.1 shows that a firm can generate more profits byincreasing its automation. This can be observed by the size of

the profit contribution from each unit of sale, which isrepresented graphically by the angle formed by the revenueline TR and the total cost lines TC1 and TC2. The angle formedby TR and TC2 is greater than the angle formed by TR andTC1. At any output beyond the break even point, more profitper unit produced is obtained. More profit is naturally

desirable. The increase in profits is the consequence of beingable to produce cheaper with machines than by using manuallabor. The use of machines allows specialization and division oflabor. Work becomes more productive. Greater productivitymeans greater output per man hour and lower labor unit costs.



It can be a deliberate strategy of the firm to start out with alarge modern plant from the beginning.

Increasing profits may be desirable, but that comes at a price.The price is that the size of potential losses increases alongwith potential profits. Indeed, a loss is incurred when salesvolume does not reach the break-even point. This can beexplained in practical terms by the fact that if sales fall off inthe case when automation and operating leverage are not used,

variable expenses can be cut (e.g. for instance by letting go ofexcess staff). But if sales of a highly automated firm decline,the equipment cannot be sold without incurring a significantloss: fixed expenses must continue to be incurred. Thisincrease in potential loss is known as operating risk.

Operating leverage can be measured in several different ways.

One of the ratios looks at increased profits as a consequenceof increased sales, and it is the ratio that is given the name ofdegree of operating leverage DOL. It is calculated by

DOL = % change in operating profit / % change in sales

Or = ((Et-Et-1)/Et-1) / ((S-St-1)/St-1)

Where E = operating profit or earnings before interest andtaxes

S = sales revenue



t = time

The practical problem with the ratio is that it depends on the

initial level of sale St-1 and profit Et-1 from which the companymoved to its target sales St and profits Et. Comparing degreesof operating leverage between companies in the industry withthe help of this ratio is not possible because all firms in theindustry have different initial sales and profit levels. The ratiois only used in financial planning by management.

For an outside analyst, it is necessary to revert to othermeasures of operating leverage. Operating leverage can beinferred from- the relative size of fixed expenses such as overhead anddepreciation expenses; - the relative size of fixed assets such as ones appearing in

common size statements; - the unit cost of goods sold for identical items produced bydifferent firms or in different years; - the number of labor hours needed to produce one item indifferent firms or different years.

Notwithstanding the distortions that are known to exist infixed assets on the balance sheet, the relative size of thefixed assets is the most common method of measuringoperating leverage when comparing firms in the same industry.Here, in particular, it would be most inappropriate to comparea firm with firms in other industries because the productive



requirements and the optimum size of fixed assets are boundto be different.

The data in Table T-10.2 is used to calculate the degrees ofoperating leverage of the two alternatives. Alternative 1 withfixed costs of 300, DOL at initial sales volume of 190 strivingfor 200 is

DOL1 = ((100 - 80) / 80 ) / ((200 - 190) / 190) = 0.25 / 0.0526

= 4.75

For many firms, automation and increased operating leverage isthe natural outcome of a wise management strategy that seeks

Table T-10.2

Data used for operating leverage illustration

Units sold 100 110 120 130 140 150 160 170 180 190 200

Total revenue 500 550 600 650 700 750 800 850 900 950 1000

FC1 300 300 300 300 300 300 300 300 300 300 300

VC1 300 330 360 390 420 450 480 510 540 570 600

TC1 600 630 660 690 720 750 780 810 840 870 900

Profit1 -100 -80 -60 -40 -20 0 20 40 60 80 100

FC2 450 450 450 450 450 450 450 450 450 450 450

VC2 200 220 240 260 280 300 320 340 360 380 400

TC2 650 670 690 710 730 750 770 790 810 830 850

Profit2 -150 -120 -90 -60 -30 0 30 60 90 120 150



to exploit all opportunities available to it. The product lifecycle implies that when a product enters its standardizationstage, firms must achieve a larger sales volume at a lower

price, and therefore a lower unit cost. In the face ofincreasing competition in a maturing product market, profitmargins can only be retained by cost savings from massproduction (unless a high price niche is found).

O P E RATING LEV E RAG E AN D SA LES INCR E AS E

There is another source of operating risk which comes fromthe increased break-even point. This is especially true in the

case where a firm needs to increase its sales volume to justifyautomation. After all, the maturing stage of the product lifecycle suggests that greater sales volumes are achievable. This

justifies once again a managerial strategy aiming at increasingsales revenue rather than just profit. It is hoped that profitswill increase after the goal of expanded sales has been

achieved. But to expand sales within a relatively short periodof time, either the existing market share must be increased,or new markets must be entered. Both of these directionsnecessitate lowering of price and increasing spending onadvertising and promotion. The results are:



a) Higher break-even point, and

b) Erosion of profit margin.

Graph G-10.2 shows the case where the break-even pointrises as a result of increases in both fixed costs from TC1to TC2 and sales targets (form break-even at 145,000,000units to break-even at 185,000 units), but without loweringselling price (i.e. total revenue Total revenue remainsunchanged). As before the profit margin improves from the

slope of Profit1 to the slope of Profit2, but not sufficiently toallow a break-even at the same level of sales as withoutoperating leverage.

Graph G-10.2

Graph G-10.2 shows that the break-even point moves up from145 to 185. The graph also shows that operating leverage will



not be an improvement in total profit if sales do not increasebeyond 240,000 units (i.e. that is the point where Profit2exceeds Profit1). The reasoning presented earlier is confirmed

that automation imposes on the firm the burden of achievingsales expansion.

Next, in Graph G-10.3, we represent the case where increasing

sales cannot be achieved without lowering price shown as aflatter Revenue 2 line than Revenue 1 line. Profit margin

improves from Profit1 to Profit2 with the increase in fixedcosts as before, but the lowering of the price cuts into theprofit margin improvement.

Graph G-10.3

With the improvement in profit margin being reduced by thelower price, the break-even point now moves up to 200,000



units from the initial break-even point at 145,000 units. Thisrequires more than 37% expansion in sales. Moreover, thechange in operations will not be beneficial if sales do not

expand beyond 290,000 units (i.e. that is the point wherePROFIT 2 exceeds PROFIT 1), which is 100% higher than theoriginal break-even point. The decrease in price shown in GraphG-10.3 is only 2%. It is doubtful that in actual markets alowering of price by 2% (as it is here) could produce the veryconsiderable (100%) sales increase necessary for the

operating leverage to improve total profit.

If significantly increasing sales necessitates an increasingmarket share (as it usually does), because the overall industrydoes not grow as fast as the company planned sales increase,achieving the sales expansion may not be easy. Indeed, if themarket is concentrated, there is a good chance for retaliationby other firms in the industry. Thus, an assessment ofoperating risk must include an investigation into marketconcentration and history of retaliation in the industry. Thisdifficulty can be especially serious in the latter phases of theproduct life cycle.

In addition to the increase in break-even point, there is also anadditional risk coming from the fact that the newly conqueredcustomers may not want to stay with the company. Thisincreased uncertainty (known as commercial risk) isdetrimental to the firm. Moreover, the potential for lossincreases a great deal more in this case than with the steady



market alternative with which the discussion of operatingleverage was started. Should the sales fall below the break-even point; the size of the loss will force the firm to close

much faster that if the firm had not automated.

O P E RATING LEV E RAG E AN D

SA LES VU LN E RA BI LITYThe foregoing has shown that the analyst must study operatingleverage and profit margins, in the context of the salesstrategy of the firm, as well as sales strategies of the otherfirms in the industry.

Using operating leverage is unwarranted if sales arevulnerable. Sales vulnerability may come from- excessive cost of conquering an expanded market share inexisting markets,- excessive cost of entering new markets,- strong likelihood that retaliation will jeopardize sale growth

strategy,- changing tastes of consumers,- potential government restrictions (e.g. antitrust action,dumping charges, collusion and price fixing).



In all these cases, producing with large variable expenses iswiser than seeking lower unit cost with larger fixed expensesthat may put the company in difficulty. Yet, taking risk is part

of doing business, and it would also be inappropriate for a firmto follow a conservative strategy, and fail to exploit additionalsales that need only a larger production volume to be achieved.This shows the importance of careful analysis based onthorough investigation of consumers and competitors.



Financial Leverage

Failure to meet its obligations is the leading cause oftermination of business. It stands to reason that to be safe,firms ought to avoid taking on debt, and should only useowner's funds. Indeed, in some cases, such as newly createdgrowth companies, it is the only advisable course of action.But, except for those few cases, most firms should use

debt. The reason is that it will increase earnings per share andtherefore the value of the stock.

Ma jor benefits from financial leverage

Let us say that Company X has an operating income (EBIT ) of$3,500 million on revenues of $20,000 million in 1996, and inthat year it had the choice to retire some of its shares to alevel of 240,000,000 shares outstanding with the proceeds ofa new debt issue (assuming that this is not violating securitiesexchange rules), or retire some of its debt by issuing newshares up to a total of 960,000,000.

Table T-11.1 shows all the consequences of varying theproportion of debt to total assets from 20% to 80% on variousmeasures of profit, earnings per share (EPS) and return oninvestment. Also included in the table are different statistics



of financial leverage explained in next section.

Table T-11.1

Company X data for financial leverage example

Debt/TotalAssets

0.66666 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Debt 16,000 4,800 7,200 9,600 12,000 14,400 16,800 19,200

Equity 8,000 19,200 16,800 14,400 12,000 9,600 7,200 4,800

TotalAssets

24,000 24,000 24,000 24,000 24,000 24,000 24,000 24,000

# shares(thousands) 400 960 840 720 600 480 360 240

Sales 40,000 40,000 40,000 40,000 40,000 40,000 40,000 40,000

COGS 20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

GrossProfit

20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

FixedExpenses

16,500 16,500 16,500 16,500 16,500 16,500 16,500 16,500

EBIT 3,500 3,500 3,500 3,500 3,500 3,500 3,500 3,500

Interest 1280 384 576 768 960 1152 1344 1536

PBT 2,220 3,116 2,924 2,732 2,540 2,348 2,156 1,964

Tax 888 1246 1170 1093 1016 939 862 786

PAT 1,332 1,870 1,754 1,639 1,524 1,409 1,294 1,178

EPS 3.33 1.95 2.09 2.28 2.54 2.94 3.59 4.91

I% 0.08 0.08 0.08 0.08 0.08 0.08 0.08 0.08ROE 0.17 0.1 0.1 0.11 0.13 0.15 0.18 0.25

ROA - 0.08 0.07 0.07 0.06 0.06 0.05 0.05

DFL - 1.12 1.2 1.28 1.38 1.49 1.62 1.78

FLI - 1.25 1.43 1.57 2.17 2.5 3.6 5

WACC - 0.09 0.08 0.09 0.09 0.09 0.09 0.09

Debt/equity 2 0.25 0.43 0.67 1 1.5 2.33 4



Interest Cv 2.73 9.11 6.08 4.56 3.65 3.04 2.6 2.28

Table T-11.1 clearly shows the increase in earnings per share

EPS as the proportion of debt is increased from 20% to 80%.EPS rises from $1.95 to $4.91.

The improvement in earnings per share is attributable to threecauses:

- Interest paid on debt is lower than the return expected by

shareholders: in Table T-11.1, the interest rate is 8%, whereasreturn on equity ROE ranges from 10% to 25%; - Interest expense is deductible from income tax, whereasearnings going to shareholders are not: interest expensescreates a tax shield for an increasing portion of income to bedistributed to shareholders;

- Fewer shares among which earnings are divided.

The tax shield can be observed by comparing the change inPAT with the change in interest expense, as the proportion ofdebt is increased from 20% to 80%. Whereas interestexpense increases by $1,152 million, from $384 million to$1,536 million (or 300%), PAT decreases by only $642 millions,from $1,870 million to $1,178 million (or 34%). The increase inEPS form a smaller PAT is attributable to a smaller number ofshares outstanding. As the proportion of debt is increasedfrom 20% to 80%, the number of shares decreases form960,000,000 to 240,000,000. The decrease in number of



outstanding shares is proportionately much larger (75%) thanthe decrease in PAT (34%). Consequently, EPS rises from$1.95 to $4.91, by $2.96 (or (1-.34)/ (1-.75) =264%). The

combination of the tax shield with the lesser amount of equityneeded, produces the increase in earnings per share and rateof return on equity. This is called financial leverage.

ASS ESSM ENT OF LEV EL OF FINANCIA L LEV E RAG E

There are several different ways of quantifying financialleverage. One such measure is degree of financial leveragefound in most financial management textbooks. The degree of

financial leverage DFL is defined as the change in earnings pershare (measured by profit after tax PAT divided by number ofshares) from one period to the next, as a result of a change inearnings (EBIT ) when debt financing was increased. DFL issometimes measured by the following formula

DFL = % change in (EPS) / % change in (EBIT ) If the number of shares outstanding does not change, thechange in EPS is equal to the change in PAT, and DFL can bewritten as

DFL = ((PAT t-PAT t-1)/PAT t-1) / ((EBIT t-EBIT t-1)/EBIT t-1)



Where PAT = profit after taxEBIT = earnings before interest and taxest=time

It can be shown that the calculation of DFL can be furthersimplified as

DFL = EBIT / PBT

In Company X, DFL for the 20% level of financial leverage is

calculated atDFL = 3,500 / 3,116 = 1.12

Table T-11.1 shows that DFL varies from 1.12 at the 20% ofdebt to 1.78 at the 80% of debt.

This measure of degree of financial leverage DFL is affected

by the initial earnings EBIT. DFL can only show whichalternative of a range of alternatives (as in the above example) will generate more financial leverage and which less. Thismeasure of financial leverage is not useful to comparecompanies whose initial profits and earnings that are mostcertainly different, and it is also inadequate for comparisons

over time for the same company.

Another measure of financial leverage, called financialleverage index FLI, attempts to capture how return on equityincreases when debt is used. FLI is calculated as



FLI = ROE / ROA

For instance, for the 20% level of debt in Company X, the

financial leverage index isFLI = 0.10 / 0.08 = 1.25

Table T-11.1 shows that FLI increases from 1.25 for the 20%level of debt to 5 at the 80% level of debt. Actually, thefinancial leverage index is nothing more than total assets

divided by equity. The inverse of this statistic is thepercentage of equity in total assets, which is already availablefrom the normalized balance sheet. The financial leverageindex gives the illusion of showing how much more profitable aleveraged company is, but earnings are eliminated by havingthem in numerator and denominator.

Because of the limited usefulness of these two formerstatistics, the simpler but more robust approach is to measurethe relative size of debt in total assets

% Debt financing = Debt / Total Assets

This seems unambiguous by comparison, and is

recommended. To the extent that the choice is essentiallybetween long term debt and equity, the same information canbe obtained by looking directly at the proportion of equityfinancing, which is the essential information we uncovered inthe financial leverage:



% Equity financing = Equity / Total Assets

The most common and straightforward assessment of financial

leverage is to relate debt to equityDebt to equity = Total Debt / Equity

Some people use net worth instead of total equity

Debt to worth = Total Debt / Net Worth

In our example in the previous section, Table T-11.1 shows thatlong term debt to equity increased from 0.25 to 4 as long termdebt increase from 20% to 80% of total assets. There areseveral variations of the debt to equity ratio that will beencountered later.

The decision to use debt or not pertains primarily to long term

debt. In fact, short term debt is sometimes referred to asspontaneous financing, implying that this borrowing is availablealmost automatically. A more precise measure of managementstrategy in using financial leverage can be obtained with thepercentage of long term debt in total assets in the normalizedbalance sheet

% Long term debt financing = Long Term Debt / Total Assets

Returning to the example of the previous section onceagain, Table T-11.1 shows the proportion of long term debtfinancing it the first line of the schedule. Sometimes, long



term debt is related to equity to reflect where the bulk ofpermanent financing comes from:

LTD to equity = Long term debt / equity

IMPACT OF TAX RAT ES ON FINANCIA L LEV E RAG E DECISI ON

The tax saving from using debt was indicated as the secondmajor reason for financial leverage. This would imply that thehigher the tax rate, the greater the tax saving from debt, andconsequently the more companies will use debt. Table T-11.6shows the aggregate equity to total assets ratio for all

corporations in the United States and the an aggregateeffective tax rate calculated by dividing aggregate tax paid byaggregate profits for all businesses in the United States forthe period of 1973 to 1996 (data from IRS Statistics ofIncome as reported in Statistical Abstract of the UnitedStates).

Table T-11.6 Proportion of equity funding and tax burden 1973-1996

. Equity/totalEffective corporate income

tax rate

1973 0.26 0.44

1974 0.25 0.45



1975 0.26 0.47

1976 0.26 0.45

1980 0.26 0.42

1982 0.26 0.411983 0.26 0.41

1984 0.26 0.41

1985 0.26 0.41

1986 0.26 0.39

1987 0.26 0.37

1990 0.26 0.33

1991 0.28 0.331992 0.28 0.33

1994 0.30 0.34

1995 0.31 0.34

1996 0.33 0.35

IRS statistic of income: Corporate Income Tax returns,

selected Financial Items in Statistical Abstracts

Table T-11.6 shows that the proportion of equity increased(form 26% to 33%), implying that the proportion of debtdecreased (from 74% to 67%) over the 23 years, while theeffective tax rate dropped (from 44% in 1965 to 35% in 1995) over the period. The hypothesis that a higher tax will pushbusinesses to borrow more seems to be verified based on thisempirical data. However, whereas the tax change of the1980's was large, the decreased use of debt was minimal anddelayed; thus the data is not fully convincing. There may besome other tax consideration than just the federal corporatetax rate (such as State corporate income taxes, other taxes



and the lifting of the capital gains tax relief) that may haveplayed a role. Moreover, tax considerations are certainly notthe only or major consideration for a capital structure

strategy.

Proportion of tax revenue collected from corporate income taxin 1988, as a percentage of the total country tax burden

United States 8.4%France 5.2%

Germany 5.3%Japan 24.4%

A rigorous comparison of debt financing among differentcountries would be informative, but it is difficult to conductbecause of the differences in capital markets and tax

provisions. A casual observation of corporate income taxburdens in Europe, Japan and the United States has amessage. In Japan, where the corporate income tax rate is thehighest, corporation are known to be much more leveragedthan in the United States. In Europe (i.e. France and Germany) the corporate income tax rate is mild because most businessrelated tax collection is concentrated in the value added tax,and as one would expect less debt is used than in the UnitedStates.



COMBINATI ON OF O P E RATING LEV E RAG E AN D FINANCIA L LEV E RAG E

As if the previous section emphasis on the danger of financialrisk was not enough, we now turn to an even more harmful butalso common situation: the combination of financial leveragewith operating leverage

PURPOS E OF BO RROWINGCompanies borrow for many different reasons. Let us considerfirst the following list of justification: working capital

expansion, equipment replacement, advertising campaign,

retirement of more costly debt. All these reasons do not

constitute seriously dangerous financial leverage, and can beconsidered benign uses of debt because in each case there is aclear purpose of improving sales or reducing costs. What is nota benign use of financial leverage is when a company uses debtto take on additional risk. For instance, when the proceedsfrom debt are used to acquire additional resources (i.e. fixed



assets for most part) which will be used to seek additionalsales. Such a strategy is at the core of capital budgeting, andis part of the necessary growth process of all firms.

There may be a few cases of down-sizing and just-in-timeconfiguration where resources increase variable costs relativeto fixed costs by reducing fixed plant. But, most corporategrowth comes from moving along the learning curve automatingand using more (rather than less) fixed plant. This means that

debt is used to increase fixed assets, fixed costs andtherefore operating leverage. This establishes that there isnatural connection between financial leverage and operatingleverage. This combination needs to be investigated.

EFF ECT OF COMBINATI ON OF O P E RATING AN D FINANCIA L LEV E RAG E

To demonstrate the effect of the combination of operatingleverage with financial leverage, let us start with the case ofmodest operating leverage and financial leverage. We continue

to use the data for Company X. Graph G-11.1 shows the patternof earnings per share with 20% debt.

Graph G-11.1



Next, let us add some operating leverage that will reduce unitcost and raise fixed costs. Fixed costs increase from 16,500to 26,500. Graph G-11.2 shows the effect of operatingleverage which is similar to what was presented previously.

Graph G-11.2



The effect of operating leverage is the usual increase in profitmargin shown by the slope of EPS line, but also an increased

break-even point. Next, financial leverage is increase byraising the proportion of debt from 20% to 40%. Graph G-11.3shows the additional rise in profit margin but the break-evenpoint is also much higher.

Graph G-11.3

Financial leverage clearly adds to profitability when combinedwith operating leverage. The potential for loss is alsoincreased. A complete summary of a range of combinations ofoperating and financial leverage levels is presented in Table T-11.13 below.



Table T-11.13

Values of EPS with increasing combined financial and operatingleverage

Debt/Total Assets Data source 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Fixed expenses=16,500

Sales=40,000 Table T-11.1 1.95 2.09 2.28 2.54 2.94 3.59 4.91

Sales=38,000 Table T-11.2 1.32 1.37 1.44 1.54 1.69 1.93 2.41

Sales=36,000 Table T-11.3 0.7 0.66 0.61 0.54 0.44 0.26 -0.09

Sales=34,000 Table T-11.4 0.07 -0.05 -0.22 -0.46 -0.81 -1.41 -2.59

Average 1.01 1.02 1.03 1.04 1.07 1.09 1.16

Standard Deviation 0.81 0.92 1.08 1.29 1.61 2.15 3.23

Fixed expenses=26,500Sales=40,000 Table T-11.9 1.95 2.09 2.28 2.54 2.94 3.59 4.91

Sales=38,000 Table T-11.10 1.01 1.02 1.03 1.04 1.06 1.09 1.16

Sales=36,000 Table T-11.11 0.07 -0.05 -0.22 -0.46 -0.81 -1.41 -2.59

Sales=34,000 Table T-11.12 -0.86 -1.13 -1.47 -1.96 -2.69 -3.91 -6.34

Average 0.54 0.48 0.41 0.29 0.13 -0.16 -0.72

Standard Deviation 1.21 1.39 1.61 1.94 2.42 3.23 4.84

Graph G-11.3 shows the pattern of EPS for different levels offinancial leverage with fixed costs at 16,500, i.e. a low level ofoperating leverage.

Graph G-11.3



Graph G-11.4 shows the pattern of EPS for different levels offinancial leverage with fixed costs at 26,500, i.e. a high levelof operating leverage.

Graph G-11.4



Each time financial leverage goes up so does the break-evenpoint; this increased output is necessary to generate the

needed contribution margin to cover the interest expense.This is not surprising because the goal of automation is toachieve a large output, and the learning curve implies that theoutput must be sold. The consequence is that more customersmust be conquered from the competition. This is clearly not aneasy task. We just saw in the previous section that financial

leverage results in financial risk embodied by an increasedvariability of earnings per share and a greater potential fordefault. Initially, financial leverage had nothing to do withcommercial risk. But, to the extent that the additional debt isused to increase output by using greater fixed costs (which isa typical usage of debt for automation), financial leverage

often also increases commercial risk.

Furthermore, to gain the additional sales and to dispose of theexpanded and cheaper output from automation, the mostcommon strategy is to lower price. Lowering price reduces theunit contribution margin and pushes the break-even point

further up. Both of which make achieving the needed earningslevel to pay fixed charges all the more difficult. The majorbenefit of financial leverage is preserved: earnings per shareare higher compared to the alternative of financing automationand sales expansion with equity. But the volatility of stock



price and potential for default are both increased because ofthe additional commercial risk.

MINIMUM AV E RAG E COST OF CAPITA L

The starting point of this approach is that funds are received

by a firm for the purpose of undertaking projects. What limitsthe number of projects that can be undertaken is the cost offunds. Thus, the optimal capital structure is the one whichgives the minimum cost of funds because that is the one thatpermits the largest number of projects to be started andguarantees maximum growth of the firm.

The various types of funds (i.e. credit, long term debt,preferred stock, common stock and retained earnings) used bya firm have each different cost (as has been established in thefirst section of this chapter). It is necessary to study how thecombination of different proportions can lower the overall

cost of capital. To do that, the weights are the proportions ofeach type of fund in the balance sheet. (In pure theory, theweights should not be the proportion of each type of fundused but the proportion of each type of fund available in themarket. But, historical and company specific circumstanceswhich justify assets and funds composition, and which are



discussed later, do not justify inclusion of the entire spectrumof financial sources.)

To make the analysis workable the assortment of funds isreduced to two: long term debt and common stock. Theweighted average cost of capital WACC is given by

WACC = d * kd (1-T ) + e * ke

Where d = proportion of debt in total assets

e = proportion of equity in total assets (note that d + e = 1) kd = long term bond yieldke = rate of return on common stockT = average corporate income tax rate

EFF ECT OF FINANCIA L LEV E RAG E ON

RAT E OF R ETURN ON COMMON ST OCKThe rate of return required by investor·s increases as financialleverage is increased. Initially, the reason for a moderate risein risk premium has been established earlier as the increasedvolatility. As soon as the level of financial leverage used



becomes substantial, a bankruptcy cost adds to the volatility.One will recall that increased potential for default onadditional debt will prompt lenders to impose restrictions on

company activity and raise interest charges. Bankruptcy costsare not born by lenders alone. Whereas lenders may beprotected by pledged collateral and other clauses,shareholders assume the brunt of corporate risk, and theirrisk premium for bankruptcy cost will rise much higher. Finally,to the extent that debt is used to finance automation and

sales expansion, the previous section showed that an additionalrisk to shareholders comes from the increased commercialrisk. These explanations justify the rising curve shown inGraph G-11.6 for the rate of return to common stock.

Graph G-11.6



EFF ECT OF FINANCIA L LEV E RAG E ON

LONG T E RM BON D YI ELD Yields on long term bonds do not suffer from the effect ofvolatility initially. But the bankruptcy cost starts to kick inearlier than for stocks, and at high level of debt, the bond

yield line rises very fast. The long term bond yield kd must berestated net of tax. Thus, in Graph G-11.2, the after tax bond

yield kd (1-T ).



PATT E RN OF AV E RAG E COST OF

CAPITA L The weighted average cost of capital is calculated in Table T-11.14 below and was shown graphically in Graph G-11.6 above.

Table T-11.14

Data for determination of WACC with increasing financial leverage andinterest rate on debt

Debt/Total Assets 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Debt 4,800 7,200 9,600 12,000 14,400 16,800 19,200

Equity 19,200 16,800 14,400 12,000 9,600 7,200 4,800

Total Assets 24,000 24,000 24,000 24,000 24,000 24,000 24,000

# shares 960 840 720 600 480 360 240

Sales 40,000 40,000 40,000 40,000 40,000 40,000 40,000

COGS 20,000 20,000 20,000 20,000 20,000 20,000 20,000Gross Profit 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Fixed Expenses 16,500 16,500 16,500 16,500 16,500 16,500 16,500

EBIT 3,500 3,500 3,500 3,500 3,500 3,500 3,500

Interest 384 576 768 1200 1728 2688 4608

PBT 3,116 2,924 2,732 2,300 1,772 812 -1,108

Tax 1246 1170 1093 920 709 325 -443

PAT 1,870 1,754 1,639 1,380 1,063 487 -665EPS 1.95 2.09 2.28 2.3 2.21 1.35 -2.77

I% 0.08 0.08 0.08 0.1 0.12 0.16 0.24

ROE 0.097 0.1 0.11 0.12 0.14 0.19 0.28

ROA 0.08 0.07 0.07 0.06 0.04 0.02 -0.03

DFL 1.12 1.2 1.28 1.52 1.98 4.31 -3.16

FLI 1.21 1.43 1.57 2 3.5 9.5 -9.33



WACC 0.09 0.08 0.09 0.09 0.1 0.12 0.17

The table and the graph reveal that the pattern is initially

down sloping because an ever greater proportion of low costtax shielded bond interest expense is mixed with moreexpensive equity. After passing through a minimum whichappears to be around 30% of debt, the average cost of capitalstarts to rise moderately at first, then asymptotically to thesteep portion of the after tax bond yield as the proportion ofequity vanishes.

SIGNIFICANC E OF TH E MINIMUMCOST OF CAPITA L

The presence of a minimum of the weighted average cost ofcapital establishes that, after taking into account all theharmful effects of financial leverage (in the form of profitvariability, stock volatility, bankruptcy cost and aggravatedcommercial risk), an optimum financial leverage strategy exists

that indicates that the proportion of debt in the funding of afirm ought to be larger than zero. In the numbers of ourexample used in Table T-11.14, it is important to note that theweighted average cost of capital is lower than even the lowestcost of capital. This verifies that a firm that would only useequity financing would have a suboptimal value. The reason for



that is that capital budgeting projects would be accepted ifthe weighted cost of capital is the cut-off rate, but would berejected if the cost of equity is the cut-off rate instead.

This minimum is, therefore, more significant than just beingthe lowest number: it tells that more projects will be chosenand more value will be added to the firm if the firm strives tohave a capital structure corresponding to it. This also impliesthat the value of the entire firm is maximum where the

average cost of capital is minimum, which is also the optimumdebt to equity proportion. This is shown in Graph G-11.7 belowusing numbers generated in Table T-11.14.

Graph G-11.7

In Graph G-11.7, earnings per share reach a maximum at a levelof debt somewhere between 40% and 50%, corresponding to



the minimum weighted average cost of capital shown in GraphG-11.6.

APP LYING TH E TH EO RY IN PRACTIC E

A first difficulty with the theory is that it is formulated in astatic context. Because a firm must continuously seek to grow,

an optimum capital structure at one point in time may not beoptimal when new funds have to be obtained. These additionalfunds will cost more than the average cost of capital: themarginal cost of capital will always be higher than the averagecost of capital. And the marginal cost will be the new cut-offrate for new projects. The basis for optimizing firm's value is

marginal cost and no longer average cost. But funds cannotusually be obtained from equity and debt in the sameproportions as the existing funds: this implies that the newmix of debt and equity will not be optimal (i.e. new funds comein lumps).

A second difficulty is that the assumption that a firm is only

financed by two types of funds must be relaxed, and when itis, the number of different funds used not only adds someminor complexity to the calculation of weighted cost of capital,but offers new choices between different alternatives (e.g.should more trade credit be used or more bank revolving line



of credit). More importantly, the cost of each alternativechanges over time: this suggests that there isn't one optimum:it changes all the time. Change does not come from outside

economic conditions only, but from project opportunities andstrategies as well. In other words, the theoretical model needsto be made dynamic.

While theoretically, including a large number of types offunds, outside conditions and internal change is a challenge

difficult to handle, a practical application is far straighterforward. Such application is usually conducted by enteringfinancial data in a spreadsheet where simulations allowmodifications ad infinitum. The starting point is not anyhypothetical value, but it is the actual recent data of thecompany under study, and the variations in yields are thosethat are foreseen in the near future. Thus, changes in allreasonable financing combinations can be put to the test ofsales instability and changing corporate strategy. Asmentioned earlier, a Monte Carlo simulation can generate aprobability distribution needed to evaluate an expected value.

A more direct approach is to study the actual cost of the

different financing sources to gather information that maysuggest whether or not the harmful effects of variability ofbankruptcy cost start to influence the funds the companyuses. Studying the cost of borrowing of a firm is a useful wayof determining what lenders, who are most diligent financialanalysts, think of the firm. It is useful to know what terms



were offered in each individual borrowing (bank credit, shortterm loans, installment loans and long term bonds). Thesenumbers must appear in notes to the financial statements.

There, the face value, maturity and coupon rate must bestated, as well as any premium or discount given when a bondwas floated and other important terms such as

- Whether the bond is secured or unsecured ,

- Method of redemption,- Right to conversion.

An indirect, but quicker method of arriving at an average costof borrowing than weighted cost of capital is by dividing theinterest expense by the outstanding debt. In the debt amount,one must be aware that all non-interest earning liabilities, such

as accrued expenses, advances, deferred income tax andprovisions should be excluded.

The analyst can tell from the interest that had to be offeredand the additional incentives present in the bond covenants,whether the firm had to pay more than it should have. Forthis, it is usually necessary to read prior year·s annual reportsand the annual reports of other firms in the industry. Only forsome 2,000 major American firms, ratings by rating services(such as Standard & Poor or Moody's) are indicativebenchmarks, but these may not be applicable to give companiesor industries.



One method is to look at the yields on a company's bondswhich were issued over the past few years in comparison tothe industry. This can be done by calculating the risk premium

on each issue: each company bond yield in excess of anindustry average (or alternatively over a risk free rate such asa treasury bills rate). If the risk premium has been decreasingor remained steady, it is an indication that the firm has notreached the optimum lowest cost of capital. On the contrary,if the risk premium has increased substantially recently, it

shows that the company may be exceeding its optimum cost ofcapital. Naturally, the interest paid is not the only factor toconsider. The more incentives a company has to offer, themore it shows that lenders consider the newer issues riskier.The incentives can also tie the hands of the company andprevent it from the needed freedom for bold investments and

innovations. For instance, restrictions on acquisition or disposalof assets that can be part of a mortgage clause that wouldclearly interfere with corporate strategic planning.

The yields on a company's bonds and the additional incentivesoffered to lenders must also be studied by the analyst inorder to determine if the firm is capable of borrowing in thefuture. If a firm has already offered lenient conversionprivileges, beneficial call or put provisions, and mortgaged allits assets, it has little to offer in new bond issues. If it hasexhausted all its borrowing capability, it means that eitherfuture planned expansion is unlikely or that it would have to be



financed either internally or by issuing new shares; thesesubjects are discussed in the following sections. Thus theanalysis of the cost of capital and bond covenants is important

knowledge for the determination of current strategicflexibility and future growth potential.



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