Leverage & Capital Structure

Prepared by Keldon Bauer
Leverage
 A firm is said to be leveraged if
it has fixed costs.
 There are two types of
leverage:
 Operating leverage – fixed costs
associated with running the firm.
 Financial leverage – fixed costs
associated with financing the firm.
 Degree of leverage
 Measure of how much leverage the
firm uses.
Capital Structure
 The mix of long-term financial
sources used to finance the
firm.
 It usually refers to the specific
proportions of debt, equity,
preferred stock, etc. used to
finance the firm.
 Only long-term sources are
included.
Breakeven Analysis
 Finding the level of operations
necessary to cover all costs.
 Can also be used to analyze the
level of profitability associated
with differing levels of sales.
 Operating breakeven point:
 The level of sales necessary to
cover all operating costs:
 The points where EBIT = $0.
A Stylized Approach
 The algebra:
 PQ-VQ-F=EBIT
 (P-V)Q-F=EBIT
 Solving for Q when EBIT = $0:
 Q=F/(P-V)
 Practical problem:
 Most companies don’t sell only one
product/service, and therefore
quantity is not as reliable as sales
volume.
Graphical Approach
Clicker Problem
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
500,000
0 10,000 20,000 30,000 40,000
Sales (units)
C
o
s
t
s
/
R
e
v
e
n
u
e
s

(
$
)
Revenue
Fixed Costs
Total Costs
Graphical Approach
Breakeven Analysis
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
0 1,000 2,000
Sales (units)
C
o
s
t
s
/
R
e
v
e
n
u
e
s

(
$
)
Sales
Costs
Operating Leverage
 Operating leverage is the use of
fixed operating costs to magnify
the effects of changes in sales
to the firm’s operating earnings.
 Operating leverage is
particularly useful if the firm can
substitute variable for fixed
costs.
Measuring Op. Leverage
 Degree of Operating Leverage:



 Stylized form:



 Note: As DOL increases, volatility in
EBIT (operating earnings) increases.
Sales in Change %
EBIT in Change %
= DOL
( )
( ) F Q V P
Q V P
DOL
÷ ÷
÷
= Q) base (at
Financial Leverage
 Financial leverage is the use of
fixed financial costs to magnify
the effects of changes in sales
to the firm’s net earnings.
 Sources of financial leverage are
primarily debt and preferred stock.
Measuring Fin. Leverage
 Degree of Financial Leverage:



 Stylized form:



 Note: As DFL increases, volatility in
net earnings increases.
EBIT in Change %
Earnings Net in Change %
= DFL
| |
|
.
|

\
|
÷
÷ ÷
=
T
PD
I EBIT
EBIT
DFL
1
EBIT) base (at
Total Leverage
 Total leverage is the use of any
fixed costs to magnify the effect
of changes in sales on the firm’s
net earnings.
 The two components of total
leverage are operating and
financial leverage.
 Categorizing two components
depend on where on the income
statement the fixed cost is found.
Measuring Total Leverage
 Degree of Total Leverage:



 Stylized form:



 Note: DTL = DOL×DFL.
Sales in Change %
Earnings Net in Change %
= DTL
( )
| |
|
.
|

\
|
÷
÷ ÷
÷
=
T
PD
I EBIT
Q V P
DTL
1
Q) base (at
Capital Structure Theory
 From WACC we know that the
most expensive sources of
capital are equity (common
stock and retained earnings).
 From leverage analysis, we
know that adding debt adds
risk.
 Adding risk adds cost to WACC.
 Therefore adding debt will increase
its cost, and the cost of equity.
Capital Structure Theory
 The goal of the financial manager
is to maximize shareholder
wealth:



 What level of debt will maximize
the value of the firm to the
shareholder?
( )
a a
k
NOPAT
k
T EBIT
V =
÷ ×
=
1
How Much Debt?
 The optimal debt level depends
on:
 Tax Benefit
 Tax shield is a component of WACC
 Any other tax shields?
 Probability of Bankruptcy
 Business Risk
 Revenue Stability
 Cost Stability
 Level of Fixed Operating Costs
How Much Debt?
 The optimal debt level depends
on:
 Agency Costs
 Risk of expropriation
 Place monitoring costs on managers
 These monitoring costs can reduce the
monitoring costs for equity investors as
well.
Other Considerations
 Pecking Order Theory:
1) Use retained earnings
2) Issue more debt
3) Issue common equity
 Signaling
 Asymmetric information
 Debt is generally seen as a
positive signal
 Depends on rates and terms
The Optimal Capital Structure
Contrast EPS Method
 The EPS-EBIT approach to capital
structure involves selecting the
capital structure that maximizes EPS
over the expected range of EBIT.
 Using this approach, the emphasis is
on maximizing the owners returns
(EPS).
 A major shortcoming of this
approach is the fact that earnings
are only one of the determinants of
shareholder wealth maximization.
 This method does not explicitly
consider the impact of risk.
EPS-EBIT Approach
to Capital Structure (cont.)
EPS Shortcoming
 Although EPS maximization is
generally good for the firm’s
shareholders, the basic shortcoming
of this method is that it does not
necessary maximize shareholder
wealth because it fails to consider
risk.
 If shareholders did not require risk
premiums (additional return) as the
firm increased its use of debt, a
strategy focusing on EPS
maximization would work.
 Unfortunately, this is not the case.
Choosing the Optimal
Capital Structure (cont.)
Choosing the Optimal
Capital Structure (cont.)
Choosing the Optimal
Capital Structure (cont.)

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