Chapter 12Chapter 12

Determining the Financing MixDetermining the Financing Mix

Chapter ObjectivesChapter Objectives

Business Risk and Financial Risk Break-even analysis Operating leverage, financial leverage, and combined leverage Calculate: operating leverage, financial leverage, and combined

leverage Optimal capital structure Capital structure theory Graph the moderate position on capital structure Agency costs and free cash flow Basic tools of capital structure management Business risk and global sales

RiskRisk

Likely variability associated with expected revenue or income streams

Business Risk Dispersion (variability) in the firm’s expected earnings before interest and taxes

Financial Risk Additional variability in earnings available to the firm’s common shareholders and the additional chance of insolvency borne by the common shareholder caused by the use of financial leverage

LeverageLeverage

Financial Leverage Financing a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholders

Operating leverage Incurrence of fixed operating costs in the firm’s income stream.

Combined leverage

Break-even AnalysisBreak-even Analysis

Determine the break-even quantity of output by examining the relationships among the firm’s cost structure, volume of output, and profit.

Break-even may be calculated in units or sales dollars

Short-run concept

Elements of Break-evenElements of Break-even

Fixed Costs or Indirect CostsVariable Costs or Direct CostsRevenueVolume

Fixed CostsFixed Costs

Indirect Costs– Fixed in total amount over some relevant range

of output. – As production volume changes, fixed costs per

unit of product changes as fixed costs are spread over a changed quantity of output (but total remains the same.)

– Vary per unit but remain fixed in total

Fixed CostsFixed Costs

Examples:– Administrative Salaries– Depreciation– Insurance– Property Taxes– Rent

Variable CostsVariable Costs

Direct CostsFixed per unit of output but vary in total as

output changesExamples:

– Direct Labor– Direct Materials– Packaging– Sales commissions

Revenue and VolumeRevenue and Volume

Total Revenue– Total sales dollars – Equal to the selling price per unit multiplied by

the quantity sold

Volume of output– Firm’s level of operations and may be stated

either as a unity quantity or as sales dollars

Break-even PointBreak-even Point

Number of units or sales dollars that must be produced and sold to arrive at EBIT = $0.

[Sales price per unit X Units sold] – [(Variable cost per unit X Units sold) +(Total fixed costs)] =EBIT = 0

ProblemProblem

Selling Price per unit is $10Variable cost per unit is $6Fixed costs are $100,000What is breakeven?

Algebraic ApproachAlgebraic ApproachPxQ – [VxQ + F] = 0(PxQ) – (VxQ) – F = 0Q (P-V) = FQb = F/P-V Where: Q = units sold P = Sales price Qb = break even level of quantity

F = Fixed Costs V = Variable Costs $100,000 / 10 – 6 = 25,000

Contribution Margin ApproachContribution Margin Approach

Sales – variable costs = contribution marginDifference between unit selling price and

unit variable costSales price – variable costs = contribution

margin (CM)Fixed costs / CM = Break-even$100,000/ $4 = 25,000

ExampleExample

Sales $ 300,000

Var costs 180,000

Revenue 120,000

Fixed Costs 100,000

EBIT $ 20,000

Per unit sales price is $10

Per unit variable cost is $6

Break-even in DollarsBreak-even in Dollars

S = Fixed costs / [1 – (Var costs/sales)]100,000/ [1 – (180,000/300,000)]BE in dollars = $250,000BE in units is 25,000 @ $10 = $250,000

Operating LeverageOperating Leverage

Responsiveness of the firm’s EBIT to fluctuation in Sales

How will a company respond to a percentage change in sales?

Percentage change in EBIT / Percentage change in sales

Operating Leverage Operating Leverage

Percentage change in EBIT / Percentage change in sales

Percentage change in EBIT =EBITt1 – EBITt / EBITt

Percentage Change in sales =

Salest1 – Salest / Salest

Operating LeverageOperating Leverage

Example : If a company has an operating leverage of 6, then

what is the change in EBIT if sales increase by 5%?

Percentage change in EBIT = Operating leverage X Percentage change in sales

Percentage change in EBIT = 5% x 6 or 30% If the firm increases sales by 5%, EBIT will

increase by 30%

Alternative Operating Alternative Operating Leverage CalculationLeverage Calculation

DOL = Revenue before fixed costs / EBIT or

Sales – Variable costs / (Sales – Variable costs – Fixed costs

Operating LeverageOperating Leverage

Operating leverage is present when:Percentage change in EBIT / Percentage

change in sales > 1.00As the degree of operating leverage

increases, the more profits will vary with a percentage change in sales

Financial LeverageFinancial Leverage

Financing a portion of the firm’s assets with securities bearing a fixed rate of return

A firm is employing financial leverage and exposing its owners to financial risk when:

Percentage change in EPS / percentage change in EBIT > 1.00

Measured by Percentage change in EPS / Percentage change in EBIT

Combining Operating Combining Operating Leverage and Financial Leverage and Financial

LeverageLeverage Changes in sales revenues cause greater changes in EBIT;

changes in EBIT create larger variations in both EPS and total earnings available to common shareholders, if the firm chooses to use financial leverage.

Combining operating and financial leverage causes rather large variations in EPS

Percentage change in EPS/Percentage change in sales Operating Leverage X Financial Leverage = Combined

Leverage

Combined LeverageCombined Leverage

OL X FL = CL

orCombined Leverage =

Q (P-V) / Q(P-V) – F – I

StructureStructure

Financial Structure– Mix of all items that appear on the right-hand

side of the company’s balance sheet

Capital Structure– Mix of the long-term sources of funds used by

the firm

Financial Structure – Current liabilities = Capital Structure

Financial StructureFinancial Structure

Requires answers to :1. How should a firm best divide its total

fund sources between short- and long-term components?

2. In what proportions relative to the total should the various forms of permanent financing be utilized?

Capital Structure ManagementCapital Structure Management

Answers the question: In what proportions relative to the total should the

various forms of permanent financing be utilized? Objective: Mix the permanent sources of funds

used by the firm in a manner that will maximize the company’s common stock price

The funds mix that will minimize the firm’s composite cost of capital—optimal capital structure

Capital Structure TheoryCapital Structure Theory

The effect of financial leverage on the overall cost of capital

Can the firm affect its overall cost of funds, either favorably or unfavorable by varying the mixture of financing used?

Firms strive to minimize the cost of using financial capital

Firm Failure--BankruptcyFirm Failure--Bankruptcy

Threat of financial distress causes the cost of debt to rise

As financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield of debt financing

Debt CapacityDebt Capacity

Maximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital.

Agency CostsAgency Costs

To ensure that agent-managers act in shareholders best interest, firms must:

1. Offer incentives – Compensation plans and perquisites

2. Monitor their work– Bonding, auditing, structuring, reviewing

The costs of the incentives and monitoring must be borne by the stockholders

Capital Structure Management Capital Structure Management and Agency Costsand Agency Costs

Capital Structure management gives rise to agency costs.

Agency problems stem from conflicts of interest

Capital structure management encompasses a natural conflict between stockholders and bondholders.

Cost of Capital-Capital Cost of Capital-Capital Structure RelationshipStructure Relationship

Interest expense is tax deductible Probability of bankruptcy directly related to the use of

financial leverage Because interest is deductible, the use of debt

financing should result in higher total market value for firms outstanding securities

Tax Shield = rd(m)(t) r = rate m = principal t = marginal tax rate