Module 3.

1
Leverage and Capital
Structure

Chapter 13
 2
Capital Structure: Leverage
1-2

➢ Capital structure refers to the mix of long term

debt and equity maintained by the firm.

➢ Leverage results from the use of fixed cost assets

to magnify returns to the firm’s owners.
✓ increased leverage raises risk/return
✓ decreased leverage lowers risk/return

➢ Management can control leverage in the capital

structure, and in turn may affect firm value.
Types Of Leverage
1-3
 4
Operating Leverage 1-4

➢ Operating leverage is the potential use of fixed

operating costs to magnify the effects of changes in
sales on the firm’s EBIT.
• If a high percentage of total costs are fixed, then the firm is
said to have a high degree of operating leverage. Companies
with high operating leverage have high fixed costs and
hence the effect of a change in sales volume on profit is
magnified.
 5
Operating Break-Even Analysis
1-5

➢ Breakeven (cost-volume-profit) Analysis is used to:

➢ determine the level of operations necessary to cover all
operating costs; and
➢ evaluate the profitability associated with various levels of
sales.

➢ The firm’s operating breakeven point (OBP) is the

level of sales necessary to cover all operating
expenses.

➢ At the OBP, operating profit (EBIT) is equal to zero.

 6
Break-Even Analysis
1-6

Formula:
EBIT = (P × Q) − FC − (VC × Q) (13.1)

where:
P = sale price per unit
Q = sale quantity in units
FC = Fixed operating cost per period
VC = Variable operating cost per unit
 7
Break-Even Analysis 1-7

Simplifying we could get:

EBIT = Q × (P − VC) − FC (13.2)

At break-even point we should have

EBIT = 0, thus:
Q = FC / (P – VC)

Q is the level of sales the firm should make to be at

least break-even
 8
Break-Even Analysis: Example 1-8

BurgerKing sells whopper burgers for $6.00 each. It

costs $2.00 to make and the overheads of the
business is $30,000 per year. What is its break-even
point? If its variable cost drops by $1 and sales
remain constant, how much money can they put into
advertising (a fixed cost) and still break even?
 9
Break-Even Analysis 1-9

A firm’s operating break-even point is sensitive to

a number of variables:
1. Fixed operating costs FC.
2. The sale price per unit P.
3. The variable operating cost per unit VC.
 10
Break-Even Analysis: Example 1-10

Fixed operating costs are $2,500, sale price per

unit is $10, variable operating cost per unit is $5,
use a graph to show the sales revenue and total
operating costs associate with different level of
sales.
 11
Break-Even Analysis: Example 1-11

•
Break Even Analysis
1-12

Changing Costs & The Operating Break Even Point:

 13
Financial Break Even 1-13

• Financial break even point is the level EBIT

when the EPS equals 0.
• A company has $10,000,000 in 8% bonds and
$6,000,000 in 10% preference shares outstanding.
What is the financial break-even point assuming a
tax rate of 40%
 14
Degree of Operating Leverage
1-14

• The degree of operating leverage (DOL) measures the

sensitivity of changes in EBIT to changes in Sales.

• Only companies that use fixed costs in the production

process will experience operating leverage.

• Changes in fixed operating costs affect operating

leverage significantly, the higher the firm’s fixed
operating costs relative to variable operating costs, the
greater the DOL.
 Operating Leverage
1-15

• The potential use of fixed operating costs to magnify the effects of

changes in sales on the firm’s EBIT.
• An increase/decrease in sales results in a more than proportional
increase/decrease in EBIT.
• Measured by the degree of operating leverage, which is calculated
by:

DOL = % Change In EBIT [ Equation 13.4]

% Change In Sales
OR

Q  ( P − VC )
DOL at base sales level Q = (13.5)
Q  ( P − VC ) − FC
 1-16
Page 574.
 Operating Leverage 1-17

• Exists whenever the DOL > 1.

• The higher the firm’s fixed operating costs

relative to variable operating costs, the greater
the degree of operating leverage.
 18
Degree of Operating Leverage 1-18

• Care must be taken when using the point

estimate because the DOL will be different at
different levels of sales quantity.

• Example: Calculate the DOL if P = $10, VC = $5,

and FC = $2,500 for Q = 750, 1,000 and 2,000
units
 Financial Leverage
1-19

• The potential use of fixed financial costs to magnify the

effects of changes in EBIT on the firm’s EPS.

• Two fixed financial costs that may be found on the firm’s

Income Statement are:
1. Interest on debt
2. Preference share dividends

• An increase/decrease in EBIT results in a more-than-

proportional increase/decrease in EPS.
1-20
 Financial Leverage 1-21

• Measured by the degree of financial leverage, which is calculated

by:

DFL = % Change In EPS [ Equation 13.6]

% Change In EBIT
OR
EBIT
DFL at base Level EBIT = (13.7)
 1 
EBIT − I −  PD  
 1 − T 
Where:
PD = Preferred stock dividend
• Exists whenever the DFL > 1.
 22
DFL: Example 1-22

A firm has an EBIT of $50,000 and has annual interest

payments of $10,000 and preference dividend payments of
$2,000. Tax is 33%, what is its DFL?
 1-23
Page 574.
 Total Leverage 1-24

• The potential use of fixed costs, both operating and

financial to magnify the effect of changes in sales
on the firm’s EPS.

• Can be viewed as the total impact of the fixed

costs on the firm’s operating and financial
structure.

• Reflects the combined impact of operating and

financial leverage on the firm.
 Total Leverage 1-25

Measured by the degree of total leverage, which is calculated

by:

DTL = % Change In EPS [ Equation 13.8]

% Change In Sales
OR

Q  ( P − VC )
DTL at base sales level = (13.9)
 1 
Q  ( P − VC ) − FC − I −  PD  
 1 − T 
OR
DTL = DOL x DFL [Equation 13.10]
Exists whenever the DFL > 1.
Total Leverage 1-26
Total Leverage
1-27
Page 574.
 The Firm’s Capital Structure 1-28

• Effective capital structure decisions can lower the cost of

capital, resulting in higher NPV’s and more acceptable
projects, thereby increasing the value of the firm.

• Capital are the long term funds of the firm.

• Debt Capital: All long term borrowings incurred by the firm.

• Equity Capital: All long term funds provided by the firm’s

owners (includes retained earnings)
External Assessment Of Capital Structure
1-29

• Can be achieved through analysis of:

➢ Debt Ratio – the higher the ratio the greater the financial
leverage.

➢ Times Interest Earned Ratio – the smaller the ratio the

greater the financial leverage.

➢ Fixed Payment Coverage Ratio – the smaller the ratio

the greater the financial leverage.

• Results will be significantly different across

different industries.
External Assessment Of Capital Structure
1-30
Page 579.
 Capital Structure Theory
• In a perfect market, capital structure does not 1-31

affect the firm’s value.

• In reality, firms strive for an optimal capital

structure that balances the benefits and costs of
debt financing.

• The main benefit of debt financing is the

deductibility of interest payments, which reduce
the tax payable by the firm, consequently
increasing the amount of earnings available for
bondholders and shareholders of the firm.
 Capital Structure Theory
1-32

• The cost of debt financing results from:

✓ The increased probability of bankruptcy caused by debt
obligations.
✓ The agency costs of the lender’s monitoring the firm’s
actions
✓ The information costs associated with managers having
more information about the firm’s prospects than
investors do.

• Risk can be compared for different capital

structures by comparing the coefficient of
variation of EPS for each structure.
Capital Structure Theory Page 581.
1-33
Capital Structure Theory
1-34
Capital Structure Theory
1-35
Value = Debt + Equity
Capital Structure Theory 1-36
Page 582.
Capital Structure Theory
1-37
Capital Structure Theory
1-38
1-39
Capital Structure Theory 1-40
 Optimal Capital Structure
1-41

The key principle in relation to optimal capital structure is that

the value of the firm is maximised when the cost of capital
is minimised.
The value of a firm can be defined as:

EBIT  (1 − T ) NOPAT
V= = (13.11)
rwacc rwacc
Where:
EBIT = Earnings before interest and taxes
T = Tax rate
NOPAT = Net operating profit after taxes
rwacc= Weighted average cost of capital
 Optimal Capital Structure
1-42

• If NOPAT is constant, V is maximised by minimising the

weighted average cost of capital, ra.

• Three cost functions:

➢ After tax cost of debt (ri): starts low due to the tax shield, and rises
with risk.
➢ Cost of equity (rs): is higher than the cost of debt and increases
faster than the cost of debt.
➢ Weighted average cost of capital (ra): declines as the debt ratio
rises, but will rise once the debt continues to increase and the costs
of debt and equity rise.
 Optimal Capital Structure Page 588.

1-43

As it’s impossible to
know or remain at the
precise optimal capital
structure, firms try to
operate within a range
that places them near
what they believe to be
the optimal capital
structure.
EBIT-EPS Approach To Capital Structure 1-44

• Involves selecting the capital structure that maximises EPS

over the expected range of EBIT.
• Focuses on maximisation of earnings rather than maximisation
of shareholder wealth.
• Five step process:
1. Obtain at least two EBIT-EPS coordinates.
2. Plot the data
3. Identify the financial break even point
4. Compare the alternative capital structures
5. Consider the risk
 1-45
Comparing Alternative Capital Structures
Comparing Alternative Capital Structures
1-46
Page 590.
Choosing The Optimal Capital Structure
1-47

• The wealth maximisation goal requires us to

consider both return and risk when making capital
structure decisions.

• We must link market value with the return and risk

associated with alternative capital structures.
 Estimating Value
1-48

• We can estimate the per share value of the firm

by:
EPS
P0 = [Equation 13.12]
rs
Maximising Value Vs. Maximising EPS 1-49
Important Considerations When Deciding
Optimal Capital Structure 1-50

• Business Risk:
• Revenue Stability
• Cash Flow
• Agency Costs:
• Contractual Obligations
• Management Preferences
• Control
• Asymmetric Information:
• External Risk Assessment
• Timing
 51
Optimal Capital Structure? 1-51

• There is an optimal capital structure exists and

that a firm can maximise its value by choosing
the optimal structure.

• It is generally believed that the value of the firm

is maximised when the cost of capital is
minimised.
 52
Factors Influencing Capital Structure
Decisions 1-52

• Stability of revenue
• Companies with stable revenue streams and. predictable
profitability can use a greater proportion of debt than those in
cyclical or high risk industries.

• The industry
• Industry norms are important, banks typically have equity
ratios of less than 10%, manufacturing industries typically
have equity ratios of 50% or more.
 Factors Influencing Capital Structure 53
Decisions 1-53

• The norm of the country

• Acceptable capital structures vary from country to country.

• Availability of cash flow

• Firms may not have the free cash flow to service large
amounts of debt.

• Debt covenants and other restrictions

• Debt covenants in old loan agreements may restrict new
lending. A common covenant is to restrict total debt to a
maximum % of total assets.
 54
Factors Influencing Capital Structure
Decisions 1-54

• Voting control
• Where existing shareholders do not wish to lose voting
control they may prefer debt to issuing new shares.

• External perceptions
• New issues of debt or equity may send adverse signals
to the market depressing share price. It may be better to
use the form of finance that will be best received by the
market.
 55
Factors Influencing Capital Structure
Decisions 1-55

• Timing
• Market values of debt or equity may be particularly
attractive at a particular time. E.g. one may prefer to
issue longer dated bonds if it is believed that interest
rates are very low and likely to rise.

• Management’s Attitude Towards Risk

• Management’s perception about the risk of using debt
versus equity to finance assets will also determine the
nature of a company’s capital structure.