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Capital Structure and Leverage

Business vs. financial risk


Optimal capital structure
Operating leverage
Capital structure theory
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Use of Debt
The use of debt increases the risk borne by
shareholders
However, using debt leads to higher
expected rates of return by shareholders.
The firms optimal capital structure is the
one that balances the influence of risk and
return and thus maximizes the firms stock
price.
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Four factors influence the firms capital


structure decision
1. Business risk
Uncertainty about future operating income
(EBIT) if it used on debt
The greater the firms business risk, the
lower its optimal debt ratio
2. The firms tax position
A major reason for using debt is that interest is
deductible, which lowers the effective cost
of debt.
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3. Financial flexibility
This is the firms ability to raise capital with
reasonable terms under adverse conditions.
The greater the probable future need for capital,
and the worse the consequences of a capital
shortage, the stronger the balance sheet should
be.
4. The conservatism or aggressiveness of
management
Firms with aggressive managers are more inclined
to use debt in an effort to boost profits.
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Business risk is affected primarily by:

Uncertainty about demand (sales).


Uncertainty about output prices.
Uncertainty about costs.
Ability to adjust output prices for changes in
input prices.
Operating leverage (the extent to which costs
are fixed).
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What is operating leverage, and how does it


affect a firms business risk?

Operating leverage is the use of fixed costs rather


than variable costs.
If most costs are fixed, hence do not decline when
demand falls, then the firm has high operating
leverage.
A high degree of operating leverage implies that a
relatively small change in sales results in a large
change in ROE.
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Operating breakpoint
The amount quantity at which Sales = Costs,
hence when EBIT = 0.
Sales = Costs
P*Q = V*Q + F
Where P is average sales price per unit of output,
Q is units of output, V is variable cost per unit
EBIT = PQ VQ- F = 0
Breakeven Q = F/(P-V)
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EX)
Plan A :F = $40,000, P =$4, V=$3, Assets = $ 400,000
Plan B: F = $120,000, P =$4, V=$2 Assets = $ 400,000

BE for A = 40,000 units


BE for B = 60,000 units

More operating leverage leads to more


business risk, for then a small sales decline
causes a big profit decline.
Rev.

Rev.

TC

Profit
TC
FC

FC
QBE

Sales

QBE

Sales

Plan B has a higher expected EBIT (and


hence ROE), but this plan also entails a
much higher probability of losses.
In general, holding other factors constant,
the higher the degree of operating leverage,
the greater the firms business risk.

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Probability

Low operating leverage


High operating leverage

EBITA

EBITB

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Degree of operating leverage (DOL)


The degree of operating leverage is defined as the
percentage change in operating income (EBIT)
that results from a given percentage change in
sales.

DOL = % change in EBIT / % change in sales

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Another way to estimate DOL is:


DOLQ = Q (P-V) / [Q (P-V) F] based on output
units Q
DOLS = S -VC / [S -VC F] based on dollar sales

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Assume the quantity produced in the previous


example is 100,000 units.
For Plan A:
DOLQ = Q (P-V) / [Q (P-V) F]
= 100,000 (4-3) / [100,000 (4-3) 40,000]
= 1.67
For Plan B:
DOLQ = 100,000 (4-2) /[100,000 (4-2) 120,000]
= 2.5
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The results suggest that if Plan A has 1%


increase in sales, its EBIT will increase by
1.67%, while for Project B the increase in
EBIT will be 2.5%.

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What is financial leverage?


Financial risk?
Financial leverage is the extent to which fixedincome securities (debt and preferred stock) are used
in a firms capital structure
Financial risk is an increase in stockholders risk
over and above the firms basic business risk,
resulting from the use of financial leverage.
The use of debt (financial leverage) concentrates the
firms business risk on its stockholders. This
concentration occurs because debtholders who
receive fixed interest payments bear none of the
business risk.
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Business Risk vs. Financial Risk


Business risk depends on business factors
such as competition, product liability, and
operating leverage.
Financial risk depends only on the types of
securities issued: More debt, more financial
risk.
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Consider 2 Hypothetical Firms

Firm U
No debt
$20,000 in assets
40% tax rate

Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate

Both firms have the same operating


leverage, business risk, and probability
distribution of EBIT. Differ only with
respect to use of debt (capital structure).
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Firm U: Unleveraged

Bad
Prob.
0.25
EBIT
$2,000
Interest
0
EBT
$2,000
Taxes (40%)
800
NI
$1,200

Economy
Avg.
Good
0.50
0.25
$3,000 $4,000
0
0
$3,000 $4,000
1,200
1,600
$1,800 $2,400
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Firm L: Leveraged
Economy
Bad
Avg.
Good

Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI

0.25
$2,000
1,200
$ 800
320
$ 480

0.50
$3,000
1,200
$1,800
720
$1,080

0.25
$4,000
1,200
$2,800
1,120
$1,680

*Same as for Firm U.


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Basic Earning Power (BEP)


BEP = EBIT / Total Assets
This ratio shows the raw earning power of the
firms assets, before the influence of taxes
and leverage.
It is useful for comparing firms with different
tax situations and different degrees of
financial leverage.
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Times Interest Earned (TIE) ratio =


EBIT / Interest charges
A measure of the firms ability to meet its
annual interest payments.

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Coefficient of variation
= standard deviation / expected return
CV shows standard measure of the risk per
unit of return, and it provides a more
meaningful basis for comparison when the
expected returns on two alternatives are not
the same.
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Firm L
Bad
Avg.
BEP*
10.0%
15.0%
ROE
4.8%
10.8%
TIE
1.67
2.5
*BEP same for Firms U and L.

Good
20.0%
12.0%
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Avg.
15.0%
9.0%
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Bad
10.0%
6.0%
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Firm U
BEP*
ROE
TIE

Good
20.0%
16.8%
3.3
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Expected Values:

E(BEP)
E(ROE)
E(TIE)

U
15.0%
9.0%

L
15.0%
10.8%
2.5

Risk Measures:

sROE

CVROE

2.12%
0.24

4.24%
0.39
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For leverage to raise expected ROE,


must have BEP > kd.
Why? If kd > BEP, then the interest
expense will be higher than the
operating income produced by
debt-financed assets, so leverage
will depress income.

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Conclusions
Basic earning power = BEP = EBIT/Total
assets is unaffected by financial leverage.
L has higher expected ROE because BEP > kd.
L has much wider ROE (and EPS) swings
because of fixed interest charges. Its higher
expected return is accompanied by higher risk.

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Degree of financial leverage (DFL)


Financial leverage takes over where operating
leverage leaves off, magnifying the effect of
changes in sales on EPS.
For this reason, operating leverage is sometimes
referred to as first-stage leverage and financial
leverage as second-stage leverage.

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The degree of financial degree is defined as the


percentage change in EPS that results from a
given percentage change in EBIT.
DFL = % change in EPS / % change in EBIT.
or
= EBIT / [EBIT I]

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Jayco has $2 million in sales, variable costs


of 70% of sales, fixed costs of $100,000 and
annual interest expense of $50,000. If
Jaycos EBIT increases by 10% how much
% will its EPS increase?

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Combining operating and financial leverage


So far, we know that:
The greater the use of fixed operating costs as
measured by DOL, the more sensitive EBIT
will be to change in sales
The greater the use of debt as measured by
DFL, the more sensitive EPS will be to
changes in EBIT

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If a firm uses a considerable amount of both


operating leverage and financial leverage
then a slight change in sales will lead to
wide fluctuations in EPS.
The degree of total leverage, which combines
the degree of operating leverage and
financial leverage, shows how a given
change in sales will affect EPS.

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DTL = DOL* DFL


= (% EBIT/ % sales) * (% EPS/ % EBIT)
= % EPS/ % sales
DTL = [Q (P-C)] / [Q(P-V)-F-I]
DTL = [S-VC] / [ S-VC-F-I ]
Ex) How much will Jaycos EPS increase if the
companys sales increase by 10%?

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