Chapter 13 Capital Structure Management in Practice

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Chapter 13Capital Structure Management in
Practice

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Operating and Financial Leverage

• From fixed operating or fixed capital costs
• Operating costs
• Costs of sales General
  administrative costs
• Capital costs
• Interest charges Preferred dividends
• Income Taxes are variable as they are a function
  of earnings.

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• Operating Leverage
• Results from fixed operating costs such that
  a change in sales revenue is magnified into a
  relative large change in EBIT
• Financial Leverage
• Results from fixed capital costs such that a
  change in EBIT is magnified into a relative large
  change in EPS
• Remember OPM
• Please see
  leverage model

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Leverage Model
?Sales
DOL
?EBIT
DFL
?EPS
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DOL

• Measured as a change in EBIT resulting from a
  given change in sales
• DOL at X
• Sales - VC - FC EBIT

Sales - Variable Costs
EBIT
Original values
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DOL
DOL at Q (P-V)Q (P-V)Q - F
Q output
A negative DOL indicates the percentage reduction
in operating losses that occurs as the result of
a 1 increase in output.
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Financial Leverage

• Financial leverage occurs when the firm employs
  funds with fixed interest payments and preferred
  stock with fixed preferred stock dividends. OPM

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DFL

• Measured as the change in EPS resulting from a
  given change in EBIT
• DFL at X

EBIT
EBIT - I - Dp / (1 - T )
P/S dividends on a before tax basis
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DCL

• Measured as a change in EPS resulting from a
  given change in sales
• DCL at X DOL x DFL
• DCL at X

Sales - Variable Costs
EBIT - I - Dp/ ( 1 - T )
Please see DCL model
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DCL Model
?Sales
DOL
?EBIT
DCL
DFL
? EPS
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DOL DFL Trade Off

• A firm can trade off operating and financial
  leverage to control DCL
• A firm with a high DOL may choose a capital
  structure with a low DFL to avoid a high DCL

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How Can You Find the Probability of EPS ?

• Probability of negative EPS
• Z
• Z EBIT - EBIT
• ?
• Loss level of EBIT is the amount of EBIT needed
  to cover interest charged and preferred dividends
• The Z value can be looked up in Table V ( Normal
  Distribution )

Loss level EBIT - Expected EBIT
Standard deviation of EBIT
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Probability of Loss Level EBIT
Z EBIT - EBIT ?
As stated in the previous slide, the loss level
EBIT is the amount of EBIT needed to cover
interest charges and preferred dividends on a
before-tax basis.
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EBIT-EPS Analysis

• Technique for comparing alternative capital
  structures
• Determine the level of EBIT where EPS would be
  identical under either Alternative A or
  Alternative B financing
• ( EBIT - I1 ) ( 1 - T ) - Dp ( EBIT -
  I2 ) ( 1 - T ) - Dp

of common shares in Alternative A
of common shares in Alternative B
Alternative A or Plan A
Alternative B or Plan B
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Graphical Analysis of EBIT - EPS
EPS
Plan 2 or Debt Financing
Advantage to Plan 1 or Equity
Financing

Plan 1 or Equity Financing
Advantage to Plan 2 or
Debt Financing
EBIT
Indifference Point
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Drawbacks of EBIT - EPS ANALYSIS

• The idea is to maximize share price not EPS
• Higher leverage might cause the Price - Earnings
  (P/E) ratio to drop

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Analyze the 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
• Examine the market evidence to see if the capital
  structure is too risky in relation to the firms
  level of Business Risk
• See Industry norms for leverage and coverage
  ratios
• Get recommendations from the firms investment
  bankers

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Cash Insolvency Analysis

• Helps managers choose their capital structure
  during a recession when liquidity is
  important
• CBr CB0 FCFr
• The firm needs cash ( or access to cash ) to
  survive a recession

FCFr Free Cash Flow during a recession CB
Cash Balance
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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

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Breakeven Analysis

• Breakeven Analysis (also known as
  cost-volume-profit analysis) is used to show the
  relationship between revenues, costs, and
  operating profits at various output levels.
• EBIT P(Q) - V(Q) - F

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Breakeven Point
Qb F P - V
The difference between the selling price per unit
and the variable price per unit, P - V, is called
the contribution margin per unit.
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Break-even dollar sales volume
Sb F 1 - (V / P)
1 - (V / P) is the contribution margin per
dollar of sales
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Target Volume
Target Volume Fixed Cost Target
Profit Contribution margin per
unit
The sales volume necessary to achieve some profit
level other than zero (breakeven).
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Limitations of Breakeven Analysis

• The selling price and variable cost per unit are
  assumed to be constant.
• Costs are classified as either fixed or variable
• Breakeven analysis assumes the firm is producing
  or selling either (a) a single product or (b) a
  constant mix of different products.
• Breakeven is usually performed for a short-term
  planning horizon, which ignores benefits and
  costs that might not be realized until future
  periods.

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Cash Breakeven Point and Cash Breakeven Analysis
Cash breakeven point F - Dep P - V
Cash breakeven sales F - Dep 1 -
(V / P)
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Conclusion

• Operating Leverage
• Financial Leverage
• Probability of Loss Level EBIT
• EBIT - EPS Analysis
• Cash Insolvency Analysis
• Breakeven Analysis