chapter13 capital structure management
TRANSCRIPT
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CONTEMPORARY FINANCIAL MANAGEMENT
Chapter 13:
Capital Structure Management
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INTRODUCTION
This chapter focuses on analytic tools to assist managers in making capital structure decisions that maximize shareholder wealth.
It also develops techniques for measuring operating and financial leverage.
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CONCEPT OF LEVERAGE Leverage, as the concept is used in finance, refers to the
ability to cause a large change in B, given a small change in A
In this Chapter, we discuss three types of leverage
Type of leverage Small change in Causes a big change in
Operating Sales EBIT
Financial EBIT EPS
Combined Sales EPS
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OPERATING LEVERAGE
The change in Earning Before Interest and Taxes (EBIT), given a change in sales revenue.
The Degree of Operating Leverage (DOL) is the percentage change in EBIT, given a 1% change in sales revenue
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FINANCIAL LEVERAGE
The change in Earnings Per Share (EPS), given a change in EBIT
The Degree of Financial Leverage (DFL) is the % change in EPS, given a 1% change in EBIT
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OPERATING AND FINANCIAL LEVERAGE
Operating and financial leverage arise due to the existence of fixed costs Fixed costs: costs that remain the same, independent of
volume Variable costs: costs that rise/fall with volume
Companies can switch the ratio between fixed and variable costs to maximize profits
Companies increase their leverage to enhance shareholder returns, but in doing so, they also increase risk 6
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EXAMPLE: FIXED VERSUS VARIABLE COST
A company installs underground lawn sprinklers. The company must choose between laying pipe manually or buying a machine to lay the pipe.
If pipe laid manually and sales volume decreases, the company can lay off workers to reduce its costs.
If pipe laid by machine, company has a fixed cost of ownership that occurs whether the machine operates or not. If sales volume increases, the fixed cost of machine ownership remains the same, whereas the variable cost of labour will rise.
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COST VERSUS OUTPUT
8Output
Cost
Fixed Costs
Variab
le Cos
ts
Semi-variable Costs
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LEVERAGE MODEL
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%Change in Sales
%Change in EBIT
%Change in EPS
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DEGREE OF OPERATING LEVERAGE
Measured as the percentage change in earnings before interest and taxes (EBIT) resulting from a one percent change in sales
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Sales - Variable CostsDOL at X =
EBIT
EBIT = Sales - Variable Costs - Fixed Costs
∆ ∆ ÷ ÷ ÷ EBIT Sales
DOL at X = EBIT Sales
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OPERATING LEVERAGE Must measure the Degree of Operating Leverage (DOL) at a
given level of sales, X
The DOL rises as EBIT approaches 0
The DOL rises as variable costs are replaced with fixed costs
When a variable cost is replaced with a fixed cost, the breakeven level of sales will increase
When a variable cost is replaced with a fixed cost, both profits and losses grow faster as sales rise and fall on either side of the breakeven point
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CONCEPT OF DOL
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Revenue
Total Cost
Fixed Cost
Quantity
Dollars
Breakeven Quantity
Low Fixed Costs with High Variable Costs
Low Breakeven; Profits/Losses Increase Slowly
Variable Cost
Profit
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CONCEPT OF DOL
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Revenue
Total Cost
Fixed Cost
Quantity
Dollars
Breakeven Quantity
High Fixed Costs with Low Variable Costs
High Breakeven; Profits/Losses Increase Quickly
Variable Cost
Profit
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DEGREE OF FINANCIAL LEVERAGE
Measured as the percentage change in earnings per share (EPS) resulting from a one percent change in EBIT
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∆ ∆ ÷ ÷ ÷ EPS EBIT
DFL at X = EPS EBIT
( )− −−
p
EBITDFL at X =
DEBIT I
1 T
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DEGREE OF FINANCIAL LEVERAGE Must measure the Degree of Financial Leverage (DFL) at a
given level of EBIT, X
DFL rises as EPS approaches 0
Divide Preferred Share dividends by one minus the tax rate to make them equivalent to interest
DFL rises as more debt is used to replace equity on the Balance Sheet
When $1 of equity is replaced with $1 of debt on the Balance Sheet, the breakeven level of EBIT will rise but EPS share will rise faster, once breakeven has been achieved 15
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DEGREE OF COMBINED LEVERAGE
Measured as the percentage change in EPS resulting from a one percent change in sales
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∆ ∆ ÷ ÷ ÷ EPS Sales
DCL at X = EPS Sales
( )− −−
p
Sales - Variable CostsDCL at X =
DEBIT I
1 T
DCL at X = DOL x DFL
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DEGREE OF COMBINED LEVERAGE MODEL
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%Change in Sales
%Change in EBIT
%Change in EPS
DOL DFL
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DOL & DFL TRADE OFF A firm can “trade off” operating and financial leverage to
control the degree of combined leverage
A firm with a high degree of operating leverage may choose a capital structure with a low degree of financial leverage to avoid a high degree of combined leverage
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FINDING THE PROBABILITY OF EPS
Breakeven EBIT is the amount of EBIT needed to just cover interest charges and preferred share dividends
The Z value tells us the number of standard deviations Breakeven EBIT is from the mean. This can be translated into the probability of achieving an EBIT of less than this amount.
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Breakeven EBIT – Expected EBITStandard deviation of EBIT
Z =
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EBIT-EPS ANALYSIS Determine the level of EBIT where EPS would be identical
under either debt or equity financing:
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( ) ( ) ( ) ( )− − − − −=d p e p
d e
EBIT - I 1 T D EBIT I 1 T D
N N
Id = Interest if debt alternative chosenIe = Interest if equity alternative chosenNd = Shares outstanding if debt alternative chosenNe = Shares outstanding if equity alternative chosenT = Firm’s marginal tax rate
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GRAPHICAL ANALYSIS OF EBIT - EPS
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EPS
EBIT
Debt Financing
EquityFinancing
IndifferencePoint
Advantage toequity financing
Advantage todebt financing
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RISKINESS OF THE CAPITAL STRUCTURE
Compute the expected level of EBIT after expansion
Estimate the variability of operating income
Compute the indifference point between two financing plans
Estimate the probability that EBIT will exceed the indifference point
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RISKINESS OF THE CAPITAL STRUCTURE
Examine the market evidence to see if the capital structure is too risky in relation to the firm’s level of:
Business risk Industry norms for leverage and coverage ratios Recommendation of the firm’s investment bankers
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FACTORS 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
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MAJOR POINTS
Leverage is the ability to create a large change in B, given a small change in A. The three types of leverage discussed are: Operating leverage Financial leverage Combined leverage (Operating & Financial)
Operating leverage arises due to the existence of fixed costs
Financial leverage arises due to the existence of debt on the Balance Sheet
High leverage is desirable, in that it magnifies returns but at a cost of additional risk
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