LEVERAGE

AND
CAPITAL STRUCTURE
Chapter 8
Sr. Jeanette M. Formentera
BSA- 4
8.1 Break-Even Analysis

2
 The study parameter
Break-Even Analysis might be:
• Production
• performed to determine the Volume
value of a variable that
makes two elements equal. • Percentage of
capacity
• Labor rate
• In economic terms:
determining a parameter • Replacement
such that revenue equals cost
cost. • Etc. 3
Cost Function:

Fixed Cost (FC) – that cost which does not vary based on production
volume. Includes building, insurance, fixed overhead (e.g.
Engineering staff), equipment recovery cost, information systems,
etc.

Variable Cost (VC) – that cost which varies as production volume

varies. Includes direct labor, materials, warranty, utilities (power
consumption), marketing, etc.

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Cost Function – cont.:

Total Cost Function

40000
35000
Cost ($/month) 30000
25000 Fixed Cost
20000 Variable Cost
15000
Total Cost
10000
5000
0
0 2000 4000 6000
Production Volume (units/month)

Total Cost = Fixed Cost + Variable Cost

Cost presented as a function of production volume. 5
Breakeven Point

Breakeven Analysis
50000
40000
$/m onth

30000
Total Cost
20000 Revenue
10000
0
0 2000 4000 6000
Production Volume
(units/month)

6
What is the breakeven point in terms of Production volume?
 Total Cost Function
40000

Breakeven Point – cont. 35000

Cost ($/month)
30000
25000 Fixed Cost
20000 Variable Cost
15000
Total Cost
10000
5000
FC = $10,000 0
0 2000 4000 6000

VC = $5000(per 1000 units) Production Volume (units/month)

Revenue = $8000(per 1000 units) Breakeven Analysis

50000

Let Q = Production Volume (000s) 40000

$/month
30000
QBE = Production Volume (000s) Total Cost
20000 Revenue
at the Breakeven point 10000
0
0 2000 4000 6000
Total Cost = Revenue Production Volume
(units/month)
FC + VC*QBE = Revenue *QBE
7
 QBE = ________________
Sensitivity Analysis
Impact of reducing or increasing one factor while
holding the other constant.

Example:

What is the QBE if VC varies from $4000 to $6000?

Variable Cost Fixed Cost Revenue QBE(1000s of unit)
$4,000 $10,000 $8,000 2.50
$4,500 $10,000 $8,000 2.86
$5,000 $10,000 $8,000 3.33
$5,500 $10,000 $8,000 4.00
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$6,000 $10,000 $8,000 5.00
Exercise:
You are an entrepreneur planning to enter the gourmet organic
burger market. Your marketing consultant believes you can
sell 150,000 burgers at $1.99 each.

Fixed costs for the business are expected to total $140,000. In

addition, variable costs will total about 0.97 per burger.

 How many burgers must you sell to break even?

 What if the price is $2.79? How many must you sell to
break even? 9
8.2 Operating, financial
and total leverages

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 Operating Leverage
Operating Leverage - The use of
fixed operating costs by the firm.
• One potential “effect” caused by the presence
of operating leverage is that a change in the
volume of sales results in a “more than
proportional” change in operating profit (or
loss). 11
 Impact of Operating
Leverage on Profits
Firm F Firm V Firm 2F
Sales $10 $11 $19.5
Operating Costs
Fixed 7 2 14
Variable 2 7 3
Operating Profit$ 1 $ 2 $ 2.5
FC/total costs .78 .22 .82
FC/sales .70 .18 .72 12
• Now, subject each firm to a 50% increase in sales for next
year.
• Which firm do you think will be more “sensitive” to the
change in sales (i.e., show the largest percentage change in
operating profit, EBIT)?

[ ] Firm F; [ ] Firm V; [ ] Firm 2F.

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 Firm F Firm V Firm 2F
Sales $15 $16.5 $29.25
Operating Costs
Fixed 7 2 14
Variable 3 10.5 4.5
Operating Profit $ 5 $ 4 $10.75
Percentage Change in
EBIT* 400% 100% 330%

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* (EBITt - EBIT t-1) / EBIT t-1
• Firm F is the most “sensitive” firm -- for it, a
50% increase in sales leads to a 400% increase
in EBIT.
• Our example reveals that it is a mistake to
assume that the firm with the largest absolute
or relative amount of fixed costs automatically
shows the most dramatic effects of operating
leverage.
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 Financial Leverage
Financial Leverage -- The use of fixed
financing costs by the firm. The British
expression is gearing.
• Financial leverage is acquired by choice.
• Used as a means of increasing the return to
common shareholders.
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 EBIT-EPS Break-Even, or
Indifference, Analysis
EBIT-EPS Break-Even Analysis -- Analysis of the
effect of financing alternatives on earnings per
share. The break-even point is the EBIT level where
EPS is the same for two (or more) alternatives.
Calculate EPS for a given level of EBIT at a given
financing structure.
(EBIT - I) (1 - t) - Pref. Div.
EPS =
# of Common Shares 17
 EBIT-EPS Chart
Basket Wonders has $2 million in LT
financing (100% common stock
equity).
• Current common equity shares = 50,000
• $1 million in new financing of either:
• All C.S. sold at $20/share (50,000 shares)
• All debt with a coupon rate of 10%
• All P.S. with a dividend rate of 9%
• Expected EBIT = $500,000
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• Income tax rate is 30%
 EBIT-EPS Calculation with New
Equity Financing
Common Stock Equity Alternative
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000 45,000
EAT $350,000 $105,000
Preferred Dividends 0 0
EACS $350,000 $105,000
# of Shares 100,000 100,000
EPS $3.50 $1.05
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* A second analysis using $150,000 EBIT rather than the expected EBIT.
 EBIT-EPS Chart
6
Earnings per Share ($)
5

4 Common
3

0
0 100 200 300 400 500 600 700

EBIT ($ thousands) 20
 Degree of Total Leverage
(DTL)
Degree of Total Leverage -- The percentage
change in a firm’s earnings per share (EPS)
resulting from a 1 percent change in output (sales).

Percentage change in
DTL at Q units earnings per share (EPS)
(or S dollars) of =
output (or sales) Percentage change in
output (or sales) 21
 Computing the DFL

Calculating the DFL

EBIT
DFL EBIT of $X =
EBIT - I - [ PD / (1 - t) ]

EBIT = Earnings before interest and taxes

I = Interest
PD = Preferred dividends
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t = Corporate tax rate
 Computing the DTL
DTL Q units (or S dollars) = ( DOL Q units (or S dollars) )
x ( DFL EBIT of X dollars )

DTL S dollars EBIT + FC

=
of sales
EBIT - I - [ PD / (1 - t) ]

DTL Q units = Q (P - V)
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Q (P - V) - FC - I - [ PD / (1 - t) ]
 DTL Example
Lisa Miller wants to determine the Degree of
Total Leverage at EBIT=$500,000. As we did
earlier, we will assume that:
 Fixed costs are $100,000
 Baskets are sold for $43.75 each
 Variable costs are $18.75 per basket
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 Computing the DTL
for All-Equity Financing
DTLS dollars = (DOL S dollars) x (DFLEBIT of $S )
DTLS dollars = (1.2 ) x ( 1.0* ) = 1.20

DTL S dollars $500,000 + $100,000

=
of sales $500,000 - 0 - [ 0 / (1 - .3) ]

= 1.20
25

*Note: No financial leverage.

 Computing the DTL
for Debt Financing
DTLS dollars = (DOL S dollars) x (DFLEBIT of $S )
DTLS dollars = (1.2 ) x ( 1.25* ) = 1.50

$500,000 + $100,000
DTL S dollars =
{ $500,000 - $100,000
of sales
- [ 0 / (1 - .3) ] }
= 1.50
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 8.3
Operational
Capital
Structure

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 Capital Structure Defined
The term capital structure is used to represent the
proportionate relationship between debt and equity.

The various means of financing represent the financial

structure of an enterprise. The left-hand side of the balance
sheet (liabilities plus equity) represents the financial structure of
a company. Traditionally, short-term borrowings are excluded
from the list of methods of financing the firm’s capital 28
 Questions while Making the Financing
Decision
How should the investment project be financed?
How does financing affect the shareholders’ risk, return and value?
Does there exist an optimum financing mix in terms of the
maximum value to the firm’s shareholders?
What factors in practice should a company consider in designing its
financing policy?
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 Features of An Appropriate
Capital Structure

Capital structure is that capital structure at that level of

debt – equity proportion where the market value per share
is maximum and the cost of capital is minimum.
Appropriate capital structure should have the following features:
Profitability
Solvency
Flexibility
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Control
 Definitions used in Capital
Structure…
• E = Total Market Value of Equity.
• D = Total Market Value of Debt.
• V = Total Market Value of the Firm.
• I = Annual Interest payment.
• NI = Net Income.
• NOI = Net Operating Income.
• Ee = Earning Available to Equity Shareholder. 31
 Patterns / Forms of Capital
Structure

The following are the forms of capital structure:

Complete equity share capital;

Different proportions of equity and preference share capital;

Different proportions of equity and debenture (debt) capital and

Different proportions of equity, preference and debenture (debt) capital.

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THANK
YOU!