You are on page 1of 18

# Chapter

14

## Capital Structure Management in Practice

Introduction
This chapter focuses on the impact of leverage on corporate profits. We will cover:
Operating and financial leverage (pp. 472-475) Breakeven analysis (Appendix 14A) EBIT-EPS analysis (pp. 482-493)

## Operating and Financial Leverage

Based on fixed operating and/or fixed capital 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

## Operating and Financial Leverage

Operating Leverage
Results from fixed operating costs such that a change in sales revenue is magnified into a relatively large change in EBIT

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

Benefits of leverage occur only within specific range of volumes until the firm needs to commit additional fixed operating or capital costs
See Table 14.2, p.475

## Breakeven Analysis (Appendix 14A,

p. 505)
Also called cost-volume-profit analysis Describes relationship among firms sales, fixed cost (FC), variable costs (VC), and EBIT/EPS at various unit output levels (Q) Main objective: at what sales level (Q) does the firm break even?

## Graphical Breakeven Analysis

Graph both revenue and cost in \$ on y axis versus output (Q) in units on x axis: Graph Total Revenue (TR = Q x Price/unit) beginning at origin Graph Total Cost (FC + VC) beginning with FC on y axis Breakeven is where TR and TC cross TR = TC
See Fig. 14A.1, p. 506

## 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 units VC/unit x units = FC (Sales/unit VC/unit) units = FC
Note: Sales/unit VC/unit = Price-VC/unit = contribution margin ( econ. profit)/unit

## Example: Allegan Mfg. Co

FC = \$1 mils, Price (P) = \$250, VC/unit = \$150 Qb = \$1 mils/\$250 \$150 = 10,000 units Incr. P by \$25 Qb = \$ 1 mils/\$275 - \$150 = 8000 units Spend CapEx of \$1 mils (\$100,000/yr in depreciation) to reduce VC/unit by \$25 Qb = \$1.1 mils/\$250 - \$125 = 8800 units
Ex: pp. 507-509 (same example in detail)

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/unit 5. Cash breakeven (p. 512-513) Qc = (FC Depr.)/Contri. Margin/unit Note: Useful for homework #7

EBIT-EPS Analysis
Use EBIT-EPS analysis for determining debt versus equity financing for individual projects 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 Breakeven

More accurate method of determining when to offer equity or debtcalculate indifference point Determine the level of EBIT where EPS would be identical under either debt or equity financing: EPS (debt fin.)=EPS (equity fin.), or (EBIT Id) (1 - T) Dp Nd
Debt financing

(EBIT Ie) (1 T) Dp = Ne
Equity financing

## Graphical Analysis of EBIT - EPS

EPS Debt Financing

Equity Financing

Indifference Point

EBIT

1.
2. 3. 4.

## Compute the expected level of EBIT after expansion.

Estimate the variability of operating income (Stnd. Dev.).

Compute the indifference point between two financing plans. Estimate the probability that EBIT will exceed the indifference point (calc. z and use Table V). Examine the market evidence to see if the capital structure 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

5.

## Ex:, pp. 485-486

Warning!
Remember, financial leverage is a double-edged sword; it enhances expected 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 whether borrowing is too risky

## Cash Insolvency Analysis (p. 487)

Helps managers choose their capital structure during a recession when liquidity is important CBR = CB0 + FCFR

CB0 = cash at beginning of period, FCFR= free cash flows during recession, and CBR = cash balance during recession (you want it to be positive)

## Firms needs cash (or access to cash) to survive a recession

Therefore, make CB0 large enough or have guaranteed access to bank credit and other sources of cash, e.g., auto company

## Factors Considered in Capital Structure Decisions

Tendency to cluster around industry average Need for funds Benchmark leverage ratios
By lenders and bond rating agencies

## Managerial risk aversion Retain control

Summary
Operating Leverage--results from fixed operating
costs such that a change in sales revenue is magnified into a relatively large change in EBIT

## Financial Leverage--results from fixed capital costs

Break-even Analysis--relationship among firms
sales, fixed cost (FC), variable costs (VC), and EBIT/EPS at various unit output levels (Q)

such that a change in EBIT is magnified into a relatively large change in EPS

## EBIT-EPS Analysis--determines whether debt or

equity financing is preferred based on maximizing EPS structure during a recession when liquidity is important

## Cash Insolvency Analysis--Helps determine capital ApplicationExamples, pp. 507-513

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.)