A-Z Answers Only

principles_of_managerial_finance_ch12.pdf

Home >Business & Finance homework help >A-Z Answers Only

ee eBook Collection

Learning Goals

Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on it.

Understand operating, financial, and total leverage and the relationships among them.

Describe the types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory.

Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero- growth valuation model.

Discuss the EBIT–EPS approach to capital structure.

Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure.

LG 6

LG 5

LG 4

LG 3

LG 2

LG 1

Why This Chapter Matters to You In Your Professional Life

Accounting: You need to understand how to calculate and analyze operating and financial leverage and to be familiar with the tax and earnings effects of various capital structures.

Information systems: You need to understand the types of capital and what capital structure is, because you will provide much of the information needed in management’s determination of the best capital structure for the firm.

Management: You need to understand leverage so that you can control risk and magnify returns for the firm’s owners and to understand capital structure theory so that you can make decisions about the firm’s optimal capital structure.

Marketing: You need to understand breakeven analysis, which you will use in pricing and product feasibility decisions.

Operations: You need to understand the impact of fixed and variable operating costs on the firm’s breakeven point and its operating leverage, because these costs will have a major impact on the firm’s risk and return.

In Your Personal Life

Like corporations, you routinely incur debt, using both credit cards for short-term needs and negotiated long-term loans. When you borrow long-term, you experience the benefits and consequences of leverage. Also, the level of your outstanding debt relative to net worth is concep- tually the same as a firm’s capital structure. It reflects your financial risk and affects the availability and cost of borrowing.

544

Leverage and Capital Structure

IS B

N : 0-558-02009-7

Principles of Managerial Finance, Twelfth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall, a division of Pearson Education, Inc.joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka

joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka

545

CVS/Caremark Corporation Optimizing Its Capital Structure

On March 22, 2007, drugstore giant CVS Pharmacymerged with pharmacy-benefits manager Caremark Rx to form CVS/Caremark Corporation.

The $26.5 billion merger created the nation’s largest

combined mail-order and retail provider of medicine.

Caremark shareholders would receive 1.67 shares of

CVS/Caremark shares for each share of Caremark stock.

In addition, each shareholder would receive a special cash dividend of $7.50.

The newly combined company is expected to offer stronger competition to Wal-Mart’s

pharmacies. In addition, CVS will have more clout when negotiating prices with drug makers and

will be positioned to slow the defection of pharmacy customers who have been filling prescrip-

tions through other channels—for example, by mail, through companies like Caremark.

Following the merger, the company set about modifying its capital structure. On May 9,

2007, CVS/Caremark’s board of directors approved a share repurchase for up to $5 billion of its

outstanding stock. By May 15, the company had completed half of the repurchase program. On

May 22, the company offered a $5.5 billion investment-grade debt offering. Part of the offering

was to be used to complete the share buyback, with the rest used to pay down a bridge loan

and for general corporate purposes The new loan will raise CVC/Caremark’s debt ratio, increasing

its financial leverage; it is expected to enable the company to significantly increase its return on

equity in 2008.

Is a capital structure consisting of increased debt better than one with a lower percentage

of debt? Not necessarily. Capital structure varies among companies in the same industry and

across industry groups. A company’s choice of debt versus equity depends on many factors.

Conditions in the equity markets may be unfavorable when a company needs to raise funds.

When interest rates are low, the debt markets become attractive.

Each type of long-term capital has its advantages.

As we learned in Chapter 11, debt costs less than equity.

Adding debt, with its fixed rate, to the capital structure creates

financial leverage, the use of fixed financial costs to magnify

returns. Leverage also increases risk. This chapter will show

that financial leverage and capital structure are closely related

concepts that can minimize the cost of capital and maximize

owners’ wealth.

Before the merger, CVS’s debt ratio was about 22.4%. After the merger, CVS/Caremark’s debt ratio was about 7.8%. What does that tell you about Caremark’s debt ratio prior to the merger?

IS B

N : 0

-5 58

-0 20

09 -7

12.1 Leverage

Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. Generally, increases in leverage result in increased return and risk, whereas decreases in leverage result in decreased return and risk. The amount of leverage in the firm’s capital structure—the mix of long-term debt and equity maintained by the firm—can significantly affect its value by affecting return and risk. Unlike some causes of risk, management has almost complete control over the risk introduced through the use of leverage. Because of its effect on value, the financial manager must understand how to measure and evaluate leverage, particularly when making capital structure decisions.

The three basic types of leverage can best be defined with reference to the firm’s income statement, as shown in the general income statement format in Table 12.1.

• Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes, or EBIT. (EBIT is a descriptive label for operating profits.)

• Financial leverage is concerned with the relationship between the firm’s EBIT and its common stock earnings per share (EPS).

• Total leverage is concerned with the relationship between the firm’s sales rev- enue and EPS.

We will examine the three types of leverage concepts in detail. First, though, we will look at breakeven analysis, which lays the foundation for leverage con- cepts by demonstrating the effects of fixed costs on the firm’s operations.

LG 2

LG 1

546 PART FOUR Long-Term Financial Decisions

leverage Results from the use of fixed- cost assets or funds to magnify returns to the firm’s owners.

capital structure The mix of long-term debt and equity maintained by the firm.

General Income Statement Format and Types of Leverage

Sales revenue

Less: Cost of goods sold Operating leverage Gross profits

Less: Operating expenses

Earnings before interest and taxes (EBIT)

Less: Interest Total leverage

Net profits before taxes

Less: Taxes Financial leverage Net profits after taxes

Less: Preferred stock dividends

Earnings available for common stockholders

Earnings per share (EPS)

TABLE 12 .1

IS B

N : 0-558-02009-7

Breakeven Analysis

Firms use breakeven analysis, also called cost-volume-profit analysis, (1) to deter- mine the level of operations necessary to cover all costs and (2) to evaluate the profitability associated with various levels of sales. The firm’s operating breakeven point is the level of sales necessary to cover all operating costs. At that point, earnings before interest and taxes (EBIT) equals $0.1

The first step in finding the operating breakeven point is to divide the cost of goods sold and operating expenses into fixed and variable operating costs. Fixed costs are a function of time (dollars per period), not sales volume, and are typi- cally contractual; rent, for example, is a fixed cost. Variable costs vary directly with sales and are a function of volume (dollars per unit), not time; shipping costs, for example, are a variable cost.2

Algebraic Approach

Using the following variables, we can recast the operating portion of the firm’s income statement given in Table 12.1 into the algebraic representation shown in Table 12.2.

P� sale price per unit

Q� sales quantity in units

FC� fixed operating cost per period

VC�variable operating cost per unit

Rewriting the algebraic calculations in Table 12.2 as a formula for earnings before interest and taxes yields Equation 12.1:

EBIT� (P�Q)�FC� (VC�Q) (12.1)

Simplifying Equation 12.1 yields

EBIT�Q� (P�VC)�FC (12.2)

CHAPTER 12 Leverage and Capital Structure 547

1. Quite often, the breakeven point is calculated so that it represents the point at which all costs—both operating and financial—are covered. Our concern in this chapter is not with this overall breakeven point.

2. Some costs, commonly called semifixed or semivariable, are partly fixed and partly variable. An example is sales commissions that are fixed for a certain volume of sales and then increase to higher levels for higher volumes. For convenience and clarity, we assume that all costs can be classified as either fixed or variable.

breakeven analysis Used to indicate the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales; also called cost-volume-profit analysis.

operating breakeven point The level of sales necessary to cover all operating costs; the point at which EBIT � $0.

Operating Leverage, Costs, and Breakeven Analysis

Algebraic Item representation

Sales revenue (P�Q)

Operating leverage Less: Fixed operating costs � FC

Less: Variable operating costs

Earnings before interest and taxes EBIT

2 (VC 3 Q)

TABLE 12 .2

IS B

N : 0

-5 58

-0 20

09 -7

As noted above, the operating breakeven point is the level of sales at which all fixed and variable operating costs are covered—the level at which EBIT equals $0. Setting EBIT equal to $0 and solving Equation 12.2 for Q yield

Q� (12.3)

Q is the firm’s operating breakeven point.3

Assume that Cheryl’s Posters, a small poster retailer, has fixed operating costs of $2,500, its sale price per unit (poster) is $10, and its variable operating cost per unit is $5. Applying Equation 12.3 to these data yields

At sales of 500 units, the firm’s EBIT should just equal $0. The firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. We can confirm this by substituting values above and below 500 units, along with the other values given, into Equation 12.1.

Graphical Approach

Figure 12.1 presents in graphical form the breakeven analysis of the data in the preceding example. The firm’s operating breakeven point is the point at which its total operating cost—the sum of its fixed and variable operating costs—equals sales revenue. At this point, EBIT equals $0. The figure shows that for sales below 500 units, total operating cost exceeds sales revenue, and EBIT is less than $0 (a loss). For sales above the breakeven point of 500 units, sales revenue exceeds total operating cost, and EBIT is greater than $0.

Changing Costs and the Operating Breakeven Point

A firm’s operating breakeven point is sensitive to a number of variables: fixed operating cost (FC), the sale price per unit (P), and the variable operating cost per unit (VC). The effects of increases or decreases in these variables can be readily seen by referring to Equation 12.3. The sensitivity of the breakeven sales volume (Q) to an increase in each of these variables is summarized in Table 12.3. As might be expected, an increase in cost (FC or VC) tends to increase the operating breakeven point, whereas an increase in the sale price per unit (P) decreases the operating breakeven point.

Assume that Cheryl’s Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50, and

Example

Q 5 $2,500

$10 2 $5 5

$2,500 $5

5 500 units

Example

FC P 2 VC

548 PART FOUR Long-Term Financial Decisions

3. Because the firm is assumed to be a single-product firm, its operating breakeven point is found in terms of unit sales, Q. For multiproduct firms, the operating breakeven point is generally found in terms of dollar sales, S. This is done by substituting the contribution margin, which is 100% minus total variable operating costs as a percentage of total sales, denoted VC%, into the denominator of Equation 12.3. The result is Equation 12.3a:

(12.3a)

This multiproduct-firm breakeven point assumes that the firm’s product mix remains the same at all levels of sales.

S 5 FC

1 2 VC%

IS B

N : 0-558-02009-7

(4) simultaneously implementing all three of these changes. Substituting the appropriate data into Equation 12.3 yields the following results:

(1) Operating breakeven point� �600 units

(2) Operating breakeven point� �3331⁄3 units

(3) Operating breakeven point� �1,000 units

(4) Operating breakeven point� �600 units $3,000

$12.50 2 $7.50

$2,500 $10 2 $7.50

$2,500 $12.50 2 $5

$3,000 $10 2 $5

CHAPTER 12 Leverage and Capital Structure 549

Sales Revenue

Total Operating Cost

Operating Breakeven Point

EB IT

Fixed Operating Cost

5000 1,000 1,500 2,000 2,500 3,000

Loss

12,000

10,000

8,000

6,000

4,000

2,000

C o st

s/ R ev

en u es

( $ )

Sales (units)

F IGURE 12 .1

Breakeven Analysis Graphical operating breakeven analysis

Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables

Effect on operating Increase in variable breakeven point

Fixed operating cost (FC) Increase

Sale price per unit (P) Decrease

Variable operating cost per unit (VC) Increase

Note: Decreases in each of the variables shown would have the opposite effect on the operating breakeven point.

TABLE 12 .3

IS B

N : 0

-5 58

-0 20

09 -7

Comparing the resulting operating breakeven points to the initial value of 500 units, we can see that the cost increases (actions 1 and 3) raise the breakeven point, whereas the revenue increase (action 2) lowers the breakeven point. The combined effect of increasing all three variables (action 4) also results in an increased operating breakeven point.

Rick Polo is considering having a new fuel-saving device installed in his car. The installed cost of the device is $240 paid up-front, plus a monthly fee of $15. He can terminate use of the device any time without penalty. Rick estimates that the device will reduce his average monthly gas consumption by 20%, which, assuming no change in his monthly mileage, translates into a savings of about $28 per month. He is planning to keep the car for 2 more years and wishes to determine whether he should have the device installed in his car.

To assess the financial feasibility of purchasing the device, Rick calculates the number of months it will take for him to break even on it. Letting the installed cost of $240 represent the fixed cost (FC), the monthly savings of $28 represent the benefit (P), and the monthly fee of $15 represent the variable cost (VC), and sub- stituting these values into the breakeven point equation, Equation 12.3, we get:

Breakeven point (in months) � $240/($28 � $15) � $240/$13 �

Because the fuel-saving device pays itself back in 18.5 months, which is less than the 24 months that Rick is planning to continue owning the car, he should have the fuel-saving device installed in his car.

We now turn our attention to the three types of leverage. It is important to recognize that the demonstrations of leverage that follow are conceptual in nature and that the measures presented are not routinely used by financial man- agers for decision-making purposes.

Operating Leverage

Operating leverage results from the existence of fixed operating costs in the firm’s income stream. Using the structure presented in Table 12.2, we can define operating leverage as the potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes.

Using the data for Cheryl’s Posters (sale price, P � $10 per unit; variable oper- ating cost, VC � $5 per unit; fixed operating cost, FC � $2,500), Figure 12.2 presents the operating breakeven graph originally shown in Figure 12.1. The additional notations on the graph indicate that as the firm’s sales increase from 1,000 to 1,500 units (Q1 to Q2), its EBIT increases from $2,500 to $5,000 (EBIT1 to EBIT2). In other words, a 50% increase in sales (1,000 to 1,500 units) results in a 100% increase in EBIT ($2,500 to $5,000). Table 12.4 includes the data for Figure 12.2 as well as relevant data for a 500-unit sales level. We can illustrate two cases using the 1,000-unit sales level as a reference point.

Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100% increase in earnings before interest and taxes (from $2,500 to $5,000).

Example

18.5 months

Personal Finance Example

550 PART FOUR Long-Term Financial Decisions

operating leverage The potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes.

IS B

N : 0-558-02009-7

Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100% decrease in earnings before interest and taxes (from $2,500 to $0).

From the preceding example, we see that operating leverage works in both directions. When a firm has fixed operating costs, operating leverage is present. An increase in sales results in a more-than-proportional increase in EBIT; a decrease in sales results in a more-than-proportional decrease in EBIT.

CHAPTER 12 Leverage and Capital Structure 551

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

5000 1,000 1,500 2,000 2,500 3,000 Q1 Q2

Sales (units)

C o st

s/ R ev

en u es

( $ )

EBIT1 ($2,500)

EBIT2 ($5,000)

Loss

EB IT

Fixed Operating Cost

Total Operating Cost

Sales Revenue

F IGURE 12 .2

Operating Leverage Breakeven analysis and operating leverage

The EBIT for Various Sales Levels

Case 2 Case 1

�50% �50%

Sales (in units) 500 1,000 1,500

Sales revenuea $5,000 $10,000 $15,000

Less: Variable operating costsb 2,500 5,000 7,500

Less: Fixed operating costs

Earnings before interest and taxes (EBIT) $ 0 $ 2,500 $ 5,000

�100% �100%

aSales revenue�$10/unit� sales in units. bVariable operating costs�$5/unit� sales in units.

2,5002,5002,500

TABLE 12 .4

IS B

N : 0

-5 58

-0 20

09 -7

4. The degree of operating leverage also depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage. Comparison of the degree of operating leverage of two firms is valid only when the same base level of sales is used for both firms.

5. Because the concept of leverage is linear, positive and negative changes of equal magnitude will always result in equal degrees of leverage when the same base sales level is used as a point of reference. This relationship holds for all types of leverage discussed in this chapter.

6. Technically, the formula for DOL given in Equation 12.5 should include absolute value signs because it is possible to get a negative DOL when the EBIT for the base sales level is negative. Because we assume that the EBIT for the base level of sales is positive, we do not use the absolute value signs.

7. When total revenue in dollars from sales—instead of unit sales—is available, the following equation, in which TR � total revenue in dollars at a base level of sales and TVC� total variable operating costs in dollars, can be used:

DOL at base dollar sales TR

This formula is especially useful for finding the DOL for multiproduct firms. It should be clear that because in the case of a single-product firm, TR � Q � P and TVC � Q � VC, substitution of these values into Equation 12.5 results in the equation given here.

5 TR 2 TVC

TR 2 TVC 2 FC

Measuring the Degree of Operating Leverage (DOL)

The degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage. It can be derived using the following equation:4

(12.4)

Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists. This means that as long as DOL is greater than 1, there is operating leverage.

Applying Equation 12.4 to cases 1 and 2 in Table 12.4 yields the following results:5

Case 1:

Case 2:

Because the result is greater than 1, operating leverage exists. For a given base level of sales, the higher the value resulting from applying Equation 12.4, the greater the degree of operating leverage.

A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is shown in Equation 12.5.6

DOL at base sales level Q (12.5)

Substituting Q�1,000, P�$10, VC�$5, and FC�$2,500 into Equation 12.5 yields the following result:

DOL at 1,000 units

The use of the formula results in the same value for DOL (2.0) as that found by using Table 12.4 and Equation 12.4.7

5 1,000 3 ($10 2 $5)

1,000 3 ($10 2 $5) 2 $2,500 5

$5,000 $2,500

5 2.0

Example

5 Q 3 (P 2 VC)

Q 3 (P 2 VC) 2 FC

2100% 250%

5 2.0

1100% 150%

5 2.0

Example

DOL 5 Percentage change in EBIT

Percentage change in sales

552 PART FOUR Long-Term Financial Decisions

degree of operating leverage (DOL) The numerical measure of the firm’s operating leverage.

IS B

N : 0-558-02009-7

See the above Focus on Practice box for discussion of operating leverage at software maker Adobe.

Fixed Costs and Operating Leverage

Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can incur fixed operating costs rather than variable operating costs and at other times may be able to substitute one type of cost for the other. For example, a firm could make fixed-dollar lease payments rather than payments equal to a specified percentage of sales. Or it could compensate sales representa- tives with a fixed salary and bonus rather than on a pure percent-of-sales commis- sion basis. The effects of changes in fixed operating costs on operating leverage can best be illustrated by continuing our example.

Assume that Cheryl’s Posters exchanges a portion of its variable operating costs for fixed operating costs by eliminating sales commissions and increasing sales salaries. This exchange results in a reduction in the variable operating cost per

Example

CHAPTER 12 Leverage and Capital Structure 553

Adobe’s Leverage

Adobe Systems, the second largest PC software company in the United States, dominates the graphic design, imaging, dynamic media, and authoring-tool soft- ware markets. Website designers favor its Photoshop and Illustrator software applications, and Adobe’s Acrobat software has become a standard for sharing documents online.

Adobe’s ability to manage discretionary expenses helps keep its bottom line strong. Adobe has an additional advan- tage: operating leverage, the use of fixed operating costs to magnify the effect of changes in sales on earnings before interest and taxes (EBIT). Adobe and its peers in the software industry incur the bulk of their costs early in a product’s life cycle, in the research and development and initial marketing stages. The up-front development costs are fixed, and subsequent pro- duction costs are practically zero. The economies of scale are

huge: Once a company sells enough copies to cover its fixed costs, incremental dollars go primarily to profit. Because the company has no long-term debt in its capital structure, its total leverage is derived only from fixed operating costs.

As demonstrated in the table below, operating leverage mag- nified Adobe’s decrease in EBIT in 2002 while magnifying the increase in EBIT from 2003 to 2005. A 5.3 percent drop in 2002 sales resulted in an EBIT reduction of 24.6 percent. In 2003, a modest increase in sales—just over 11 percent— became a 33 percent increase

in EBIT. In 2006, Adobe, for the first time in 5 years, appeared to have lost its operating leverage. This can be attributed to its acquisition of Macromedia for approximately $3.5 billion in December 2005 and related restructuring charges during fiscal 2006. Once it has digested this purchase, Adobe should see its operating leverage rebound.

The table below demon- strates the impact of operating leverage on Adobe Systems in fiscal years (FYs) 2002–2006.

■ What might cause the gradual decrease in operating leverage for Adobe?

IN P

R A

C T

IC E

Focus on Practice

Item FY2002 FY2003 FY2004 FY2005 FY2006

Sales revenue (millions) $1,165 $1,295 $1,666 $1,966 $2,575

EBIT (millions) $285 $380 $608 $766 $678

(1) Percent change in sales �5.3% 11.2% 28.6% 18.0% 31.0%

(2) Percent change in EBIT �24.6% 33.3% 60.0% 26.0% �11.5%

DOL [(2) � (1)] 4.6 3.0 2.1 1.4 �0.4

IS B

N : 0

-5 58

-0 20

09 -7

unit from $5 to $4.50 and an increase in the fixed operating costs from $2,500 to $3,000. Table 12.5 presents an analysis like that in Table 12.4, but using the new costs. Although the EBIT of $2,500 at the 1,000-unit sales level is the same as before the shift in operating cost structure, Table 12.5 shows that the firm has increased its operating leverage by shifting to greater fixed operating costs.

With the substitution of the appropriate values into Equation 12.5, the degree of operating leverage at the 1,000-unit base level of sales becomes

DOL at 1,000 units�

Comparing this value to the DOL of 2.0 before the shift to more fixed costs makes it clear that the higher the firm’s fixed operating costs relative to variable operating costs, the greater the degree of operating leverage.

Financial Leverage

Financial leverage results from the presence of fixed financial costs in the firm’s income stream. Using the framework in Table 12.1, we can define financial leverage as the potential use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share. The two fixed financial costs that may be found on the firm’s income statement are (1) interest on debt and (2) preferred stock dividends. These charges must be paid regardless of the amount of EBIT available to pay them.8

1,000 3 ($10 2 $4.50)

1,000 3 ($10 2 $4.50) 2 $3,000 5

$5,500 $2,500

5 2.2

554 PART FOUR Long-Term Financial Decisions

8. As noted in Chapter 7, although preferred stock dividends can be “passed” (not paid) at the option of the firm’s directors, it is generally believed that payment of such dividends is necessary. This text treats the preferred stock div- idend as a contractual obligation, not only to be paid as a fixed amount, but also to be paid as scheduled. Although failure to pay preferred dividends cannot force the firm into bankruptcy, it increases the common stockholders’ risk because they cannot be paid dividends until the claims of preferred stockholders are satisfied.

financial leverage The potential use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share.

Operating Leverage and Increased Fixed Costs

Case 2 Case 1

�50% �50%

Sales (in units) 500 1,000 1,500

Sales revenuea $5,000 $10,000 $15,000

Less: Variable operating costsb 2,250 4,500 6,750

Less: Fixed operating costs

Earnings before interest and taxes (EBIT) �$ 250 $ 2,500 $ 5,250

�110% �110%

aSales revenue was calculated as indicated in Table 12.4. bVariable operating costs�$4.50/unit� sales in units.

3,0003,0003,000

TABLE 12 .5

IS B

N : 0-558-02009-7

Chen Foods, a small Asian food company, expects EBIT of $10,000 in the current year. It has a $20,000 bond with a 10% (annual) coupon rate of interest and an issue of 600 shares of $4 (annual dividend per share) preferred stock outstanding. It also has 1,000 shares of common stock outstanding. The annual interest on the bond issue is $2,000 (0.10 � $20,000). The annual dividends on the preferred stock are $2,400 ($4.00/share�600 shares). Table 12.6 presents the EPS corre- sponding to levels of EBIT of $6,000, $10,000, and $14,000, assuming that the firm is in the 40% tax bracket. Two situations are shown:

Case 1 A 40% increase in EBIT (from $10,000 to $14,000) results in a 100% increase in earnings per share (from $2.40 to $4.80).

Case 2 A 40% decrease in EBIT (from $10,000 to $6,000) results in a 100% decrease in earnings per share (from $2.40 to $0).

The effect of financial leverage is such that an increase in the firm’s EBIT results in a more-than-proportional increase in the firm’s earnings per share, whereas a decrease in the firm’s EBIT results in a more-than-proportional decrease in EPS.

Measuring the Degree of Financial Leverage (DFL)

The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage. Computing it is much like computing the degree of operating leverage. The following equation presents one approach for obtaining the DFL.9

Example

CHAPTER 12 Leverage and Capital Structure 555

9. This approach is valid only when the same base level of EBIT is used to calculate and compare these values. In other words, the base level of EBIT must be held constant to compare the financial leverage associated with different levels of fixed financial costs.

degree of financial leverage (DFL) The numerical measure of the firm’s financial leverage.

The EPS for Various EBIT Levelsa

Case 2 Case 1

�40% �40%

EBIT $6,000 $10,000 $14,000

Less: Interest (I)

Net profits before taxes $4,000 $ 8,000 $12,000

Less: Taxes (T�0.40)

Net profits after taxes $2,400 $ 4,800 $ 7,200

Less: Preferred stock dividends (PD)

Earnings available for common (EAC) $ 0 $ 2,400 $ 4,800

Earnings per share (EPS) �$0 �$2.40 �$4.80

�100% �100%

aAs noted in Chapter 1, for accounting and tax purposes, interest is a tax-deductible expense, whereas dividends must be paid from after-tax cash flows.

$4,800

1,000

$2,400

1,000 $0

1,000

2,4002,4002,400

4,8003,2001,600

2,0002,0002,000

TABLE 12 .6

IS B

N : 0

-5 58

-0 20

09 -7

(12.6)

Whenever the percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. This means that whenever DFL is greater than 1, there is financial leverage.

Applying Equation 12.6 to cases 1 and 2 in Table 12.6 yields

Case 1:

Case 2:

In both cases, the quotient is greater than 1, so financial leverage exists. The higher this value, the greater the degree of financial leverage.

Shanta and Ravi Shandra, a married couple with no children, wish to assess the impact of additional long-term borrowing on their degree of financial leverage (DFL). The Shandras currently have $4,200 available after meeting all of their monthly living (operating) expenses, before making monthly loan payments. They currently have monthly loan payment obligations of $1,700 and are consid- ering the purchase of a new car, which would result in a $500 per month increase (to $2,200) in their total monthly loan payments. Because a large portion of Ravi’s monthly income represents commissions, the Shandras feel that the $4,200 per month currently available for making loan payments could vary by 20% above or below that amount.

In order to assess the potential impact of the additional borrowing on their financial leverage, the Shandras calculate their DFL for both their current ($1,700) and proposed ($2,200) loan payments as follows, using the currently available $4,200 as a base and a 20% change.

Based on their calculations, the amount the Shandras will have available after loan payments with their current debt changes by 1.68% for every 1% change in the amount they will have available for making the loan payments. This is con- siderably less responsive—and therefore less risky—than the 2.10% change in the amount available after loan payments for each 1% change in the amount avail- able for making loan payments with the proposed additional $500 in monthly

Personal Finance Example

2100% 240%

5 2.5

1100% 140%

5 2.5

Example

DFL 5 Percentage change in EPS

Percentage change in EBIT

556 PART FOUR Long-Term Financial Decisions

Current DFL Proposed DFL

Available for making loan payments $4,200 (�20%) $5,040 $4,200 (�20%) $5,040

Less: Loan payments

Available after loan payments $2,500 (�33.6%) $3,340 $2,000 (�42%) $2,840

DFL � �33.6%/�20% � DFL � �42%/�20% � 2.101.68

2,2002,2001,7001,700

IS B

N : 0-558-02009-7

debt payments. Although it appears that the Shandras can afford the additional loan payments, they must decide if, given the variability of Ravi’s income, they feel comfortable with the increased financial leverage and risk.

A more direct formula for calculating the degree of financial leverage at a base level of EBIT is given by Equation 12.7, where the notation from Table 12.6 is used.10 Note that in the denominator, the term 1/(1�T) converts the after-tax preferred stock dividend to a before-tax amount for consistency with the other terms in the equation.

(12.7)

Substituting EBIT � $10,000, I � $2,000, PD � $2,400, and the tax rate (T � 0.40) into Equation 12.7 yields the following result:

Note that the formula given in Equation 12.7 provides a more direct method for calculating the degree of financial leverage than the approach illustrated using Table 12.6 and Equation 12.6.

Total Leverage

We also can assess the combined effect of operating and financial leverage on the firm’s risk by using a framework similar to that used to develop the individual concepts of leverage. This combined effect, or total leverage, can be defined as the potential use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the firm’s earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure.

Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: variable operating costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000, and preferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding. Table 12.7 on page 558 presents the levels of earnings per share associated with the expected sales of 20,000 units and with sales of 30,000 units.

Example

5 $10,000 $4,000

5 2.5

DFL at $10,000 EBIT 5 $10,000

$10,000 2 $2,000 2 a$2,400 3 1 1 2 0.40

Example

DFL at base level EBIT 5 EBIT

EBIT 2 I 2 aPD 3 1 1 2 T

CHAPTER 12 Leverage and Capital Structure 557

10. By using the formula for DFL in Equation 12.7, it is possible to get a negative value for the DFL if the EPS for the base level of EBIT is negative. Rather than show absolute value signs in the equation, we instead assume that the base-level EPS is positive.

total leverage The potential use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the firm’s earnings per share.

IS B

N : 0

-5 58

-0 20

09 -7

558 PART FOUR Long-Term Financial Decisions

The table illustrates that as a result of a 50% increase in sales (from 20,000 to 30,000 units), the firm would experience a 300% increase in earnings per share (from $1.20 to $4.80). Although it is not shown in the table, a 50% decrease in sales would, conversely, result in a 300% decrease in earnings per share. The linear nature of the leverage relationship accounts for the fact that sales changes of equal magnitude in opposite directions result in EPS changes of equal magnitude in the corresponding direction. At this point, it should be clear that whenever a firm has fixed costs—operating or financial—in its structure, total leverage will exist.

Measuring the Degree of Total Leverage (DTL)

The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage. It can be computed much as operating and financial leverage are com- puted. The following equation presents one approach for measuring DTL:11

(12.8)DTL 5 Percentage change in EPS

Percentage change in sales

11. This approach is valid only when the same base level of sales is used to calculate and compare these values. In other words, the base level of sales must be held constant if we are to compare the total leverage associated with dif- ferent levels of fixed costs.

degree of total leverage (DTL) The numerical measure of the firm’s total leverage.

The Total Leverage Effect

�50%

Sales (in units) 20,000 30,000

Sales revenuea $100,000 $150,000

Less: Variable operating costsb 40,000 60,000

Less: Fixed operating costs

Earnings before interest and taxes (EBIT) $ 50,000 $ 80,000

�60%

Less: Interest

Net profits before taxes $ 30,000 $ 60,000

Less: Taxes (T�0.40)

Net profits after taxes $ 18,000 $ 36,000

Less: Preferred stock dividends

Earnings available for common $ 6,000 $ 24,000

Earnings per share (EPS) �$1.20

�300%

aSales revenue�$5/unit� sales in units. bVariable operating costs�$2/unit� sales in units.

$24,000

5,000 5 $4.80

$6,000

5,000

12,00012,000

DFL 5 1300% 160%

5 5.024,00012,000

20,00020,000 DTL 5

1300% 150%

5 6.0

10,00010,000

DOL 5 160% 150%

5 1.2

TABLE 12 .7

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 559

Whenever the percentage change in EPS resulting from a given percentage change in sales is greater than the percentage change in sales, total leverage exists. This means that as long as the DTL is greater than 1, there is total leverage.

Applying Equation 12.8 to the data in Table 12.7 yields

Because this result is greater than 1, total leverage exists. The higher the value, the greater the degree of total leverage.

A more direct formula for calculating the degree of total leverage at a given base level of sales, Q, is given by Equation 12.9,12 which uses the same notation that was presented earlier:

(12.9)

Substituting Q � 20,000, P � $5, VC � $2, FC � $10,000, I � $20,000, PD � $12,000, and the tax rate (T�0.40) into Equation 12.9 yields

DTL at 20,000 units

Clearly, the formula used in Equation 12.9 provides a more direct method for cal- culating the degree of total leverage than the approach illustrated using Table 12.7 and Equation 12.8.

Relationship of Operating, Financial, and Total Leverage

Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will cause total leverage to be high. The opposite will also be true. The relationship between oper- ating leverage and financial leverage is multiplicative rather than additive. The relationship between the degree of total leverage (DTL) and the degrees of oper- ating leverage (DOL) and financial leverage (DFL) is given by Equation 12.10.

DTL�DOL�DFL (12.10)

5 $60,000 $10,000

5 6.0

5 20,000 3 ($5 2 $2)

20,000 3 ($5 2 $2) 2 $10,000 2 $20,000 2 a$12,000 3 1 1 2 0.40

Example

DTL at base sales level Q 5 Q3 (P 2 VC)

Q3 (P2VC)2 FC2 I2 aPD3 1 12 T

DTL 5 1300% 150%

5 6.0

Example

12. By using the formula for DTL in Equation 12.9, it is possible to get a negative value for the DTL if the EPS for the base-level of sales is negative. For our purposes, rather than show absolute value signs in the equation, we instead assume that the base-level EPS is positive.

IS B

N : 0

-5 58

-0 20

09 -7

560 PART FOUR Long-Term Financial Decisions

Substituting the values calculated for DOL and DFL, shown on the right-hand side of Table 12.7, into Equation 12.10 yields

DTL�1.2�5.0�6.0

The resulting degree of total leverage is the same value that we calculated directly in the preceding examples.

The Focus on Ethics box above considers some ethical issues relating to the topic of leverage.

REVIEW QUESTIONS

12–1 What is meant by the term leverage? How are operating leverage, finan- cial leverage, and total leverage related to the income statement?

12–2 What is the operating breakeven point? How do changes in fixed oper- ating costs, the sale price per unit, and the variable operating cost per unit affect it?

Example

The Buyout Binge

The 1980s were the decade of leveraging, or adding debt to capital structure. A Harvard Business Review article warned managers that if they didn’t “lever up” with debt, a hostile takeover would do it for them. Much of the debt binge had to be reversed in the 1990s—the decade of de-levering.

In 2007, the deals were heating up again. The acquirers this time were private-equity firms. Renewed concern arose that companies might be adding debt to the balance sheet as a defensive measure. Health Management Associates did so, announcing in January 2007 that it would take on $2.4 billion in new debt to finance a one-time $10-per-share dividend. While the move would lower HMA’s credit rating from investment grade to junk levels, CFO Robert Farnham noted in a conference call that it would drop the com- pany’s cost of capital from the

low teens to 7.5 percent to 8 percent. The move makes a private-equity buyout nearly impossible. Anheuser-Busch signaled that it was pursuing a similar strategy when it announced in December 2006 that it was moving to an “aggres- sive leverage target.”

Following the special divi- dend announcement, Health Management Associate’s stock value fell approximately 8 per- cent. Although both the stock price and bond prices might fall due to overleveraging, stock- holders were content because the cash they received more than offset the drop in the stock price. Moving to a highly lever- aged position may help share- holders, but it is generally harmful to the interests of bond- holders and other lenders.

As private-equity funds have consistently beaten market returns, money has poured in by the billions. By some estimates,

U.S. private-equity firms collec- tively were sitting on a $400 bil- lion war chest. Combine that cash with leverage, and private- equity’s buying power increases fourfold or fivefold.

The danger, of course, is that with that much money available, deals will be made that should not be made, and some deals will simply be so expensive that making them pay off could be difficult. Witness the Chrysler buyout by Germany’s Daimler Corpora- tion: The initial deal in 1998 was for $36 bil-lion. In 2007, Cerebus Capital Management LP, a private-equity firm, bought 80 percent of Chrysler Group from DaimlerChrysler AG for a mere $7.4 billion.

■ What effect would a decreased cost of capital have on a firm’s future investments?

IN P

R A

C T

IC E

Focus on Ethics

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 561

12–3 What is operating leverage? What causes it? How is the degree of oper- ating leverage (DOL) measured?

12–4 What is financial leverage? What causes it? How is the degree of financial leverage (DFL) measured?

12–5 What is the general relationship among operating leverage, financial leverage, and the total leverage of the firm? Do these types of leverage complement one another? Why or why not?

12.2 The Firm’s Capital Structure

Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables.13 Poor capital structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects—and thereby increasing the value of the firm. This sec- tion links together many of the concepts presented in Chapters 4, 5, 6, 7, and 11 and the discussion of leverage in this chapter.

Types of Capital

All of the items on the right-hand side of the firm’s balance sheet, excluding cur- rent liabilities, are sources of capital. The following simplified balance sheet illus- trates the basic breakdown of total capital into its two components, debt capital and equity capital.

The cost of debt is lower than the cost of other forms of financing. Lenders demand relatively lower returns because they take the least risk of any long-term contributors of capital: (1) They have a higher priority of claim against any earn- ings or assets available for payment. (2) They can exert far greater legal pressure against the company to make payment than can owners of preferred or common

LG 4

LG 3

13. Of course, although capital structure is financially important, it—like many business decisions—is generally not so important as the firm’s products or services. In a practical sense, a firm can probably more readily increase its value by improving quality and reducing costs than by fine-tuning its capital structure.

Balance Sheet

Long-term debt

Assets Stockholders’ equity

Preferred stock

Common stock equity

Common stock

Retained earnings

Current liabilities

Equity capital

Debt capital

Total capital

Hint The various types and characterisitcs of corporate bonds, a major source of debt capital, were discussed in detail in Chapter 6.

IS B

N : 0

-5 58

-0 20

09 -7

562 PART FOUR Long-Term Financial Decisions

stock. (3) The tax deductibility of interest payments lowers the debt cost to the firm substantially.

Unlike debt capital, which must be repaid at some future date, equity capital is expected to remain in the firm for an indefinite period of time. The two basic sources of equity capital are (1) preferred stock and (2) common stock equity, which includes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and then pre- ferred stock. Our concern here is the relationship between debt and equity capital. Because of equity’s secondary position relative to debt, suppliers of equity capital take greater risk than suppliers of debt capital and therefore must be compensated with higher expected returns.

External Assessment of Capital Structure

We saw earlier that financial leverage results from the use of fixed-cost financing, such as debt and preferred stock, to magnify return and risk. The amount of leverage in the firm’s capital structure can affect its value by affecting return and risk. Those outside the firm can make a rough assessment of capital structure by using measures found in the firm’s financial statements. Some of these important debt ratios were presented in Chapter 2. For example, a direct measure of the degree of indebtedness is the debt ratio. The higher this ratio, the greater the rel- ative amount of debt (or financial leverage) in the firm’s capital structure. Measures of the firm’s ability to meet contractual payments associated with debt include the times interest earned ratio and the fixed-payment coverage ratio. These ratios provide indirect information on financial leverage. Generally, the smaller these ratios, the greater the firm’s financial leverage and the less able it is to meet payments as they come due.

The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics. Table 12.8 presents the debt and times interest earned ratios for selected industries and lines of business. Significant industry differences can be seen in these data. Differences in debt posi- tions are also likely to exist within an industry or line of business.

Those who lend to individuals, like lenders to corporations, typically use ratios to assess the applicant’s ability to meet the contractual payments associated with the requested debt. The lender, after obtaining information from a loan application and other sources, calculates ratios and compares them to predeter- mined allowable values. Typically, if the applicant’s ratio values are within the acceptable range, the lender will make the requested loan.

The best example of this process is a real estate mortgage loan application. The mortgage lender usually invokes the following two requirements:

1. Monthly mortgage payments � 25% to 30% of monthly gross (before-tax) income

2. Total monthly installment payments (including the mortgage payment) � 33% to 38% of monthly gross (before-tax) income

Assume that the Loo family is applying for a mortgage loan. The family’s monthly gross (before-tax) income is $5,380, and they currently have monthly

Personal Finance Example

Hint Key differences between these two types of capital, relative to voice in management, claims on income and assets, maturity, and tax treatment, were summarized in Chapter 7, Table 7.1.

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 563

installment loan obligations that total $560. The $200,000 mortgage loan they are applying for will require monthly payments of $1,400. The lender requires (1) the monthly mortgage payment to be less than 28% of monthly gross income and (2) total monthly installment payments (including the mortgage payment) to be less than 37% of monthly gross income. The lender calculates and evaluates these ratios for the Loos, as shown below.

1. Mort. pay./Gross income � $1,400/$5,380 � 26% � 28% maximum, therefore OK

2. Tot. instal. pay./Gross income � ($560 � $1,400)/$5,380 � $1,960/$5,380 � 36.4% � 37% maximum, therefore OK

Because the Loos’ ratios meet the lender’s standards, assuming they have ade- quate funds for the down payment and meet other lender requirements, the Loos will be granted the loan.

Capital Structure of Non-U.S. Firms

In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. Most of the reasons relate to the fact that U.S. capital markets are more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries. In most European countries and especially in Japan and other Pacific Rim nations, large commercial banks are more actively involved in the financing of corporate activity than has

Debt Ratios for Selected Industries and Lines of Business (Fiscal Years Ended 4/1/05 through 3/31/06)

Times interest Times interest Industry or line of business Debt ratio earned ratio Industry or line of business Debt ratio earned ratio

Manufacturing industries

Books printing 70.4% 2.9

Dairy products 70.3 3.1

Electronic computers 71.1 4.7

Iron and steel forgings 59.9 4.9

Machine tools, metal cutting types 64.1 4.3

Wines and distilled alcoholic beverages 66.9 5.0

Women’s and girls’ dresses 64.1 2.7

Wholesaling industries

Furniture 69.3 4.0

General groceries 70.5 3.0

Men’s and boys’ clothing 66.9 3.7

TABLE 12 .8

Retailing industries

Department stores 65.0% 3.0

New car dealers 82.2 1.8

Supermarkets and grocery stores 72.9 3.4

Service industries

Advertising agencies 81.2 8.8

General automotive repair 85.3 2.8

Insurance agencies and brokerages 80.4 7.3

Offices of Certified Public Accountants 71.3 10.2

Note: The Risk Management Association recommends that these ratios be regarded only as general guidelines and not as absolute industry norms. No claim is made as to the representativeness of these figures.

IS B

N : 0

-5 58

-0 20

09 -7

564 PART FOUR Long-Term Financial Decisions

been true in the United States. Furthermore, in many of these countries, banks are allowed to make large equity investments in nonfinancial corporations—a prac- tice prohibited for U.S. banks. Finally, share ownership tends to be more tightly controlled among founding-family, institutional, and even public investors in Europe and Asia than it is for most large U.S. corporations. Tight ownership enables owners to understand the firm’s financial condition better, resulting in their willingness to tolerate a higher degree of indebtedness.

On the other hand, similarities do exist between U.S. corporations and cor- porations in other countries. First, the same industry patterns of capital structure tend to be found all around the world. For example, in nearly all countries, phar- maceutical and other high-growth industrial firms tend to have lower debt ratios than do steel companies, airlines, and electric utility companies. Second, the cap- ital structures of the largest U.S.-based multinational companies, which have access to capital markets around the world, typically resemble the capital struc- tures of multinational companies from other countries more than they resemble those of smaller U.S. companies. Finally, the worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance. Over time, the differences in the capital structures of U.S. and non-U.S. firms will probably lessen.

Capital Structure Theory

Research suggests that there is an optimal capital structure range. It is not yet pos- sible to provide financial managers with a specified methodology for use in deter- mining a firm’s optimal capital structure. Nevertheless, financial theory does offer help in understanding how a firm’s chosen financing mix affects the firm’s value.

In 1958, Franco Modigliani and Merton H. Miller14 (commonly known as “M and M”) demonstrated algebraically that, assuming perfect markets,15 the capital structure that a firm chooses does not affect its value. Many researchers, including M and M, have examined the effects of less restrictive assumptions on the relationship between capital structure and the firm’s value. The result is a the- oretical optimal capital structure based on balancing the benefits and costs of debt financing. The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income. The cost of debt financing results from (1) the increased probability of bankruptcy caused by debt obligations, (2) the agency costs of the lender’s constraining the firm’s actions, and (3) the costs associated with managers having more information about the firm’s prospects than do investors.

Tax Benefits

Allowing firms to deduct interest payments on debt when calculating taxable income reduces the amount of the firm’s earnings paid in taxes, thereby making more earnings available for bondholders and stockholders. The deductibility of

14. Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” American Economic Review (June 1958), pp. 261–297.

15. Perfect-market assumptions include (1) no taxes, (2) no brokerage or flotation costs for securities, (3) symmet- rical information—investors and managers have the same information about the firm’s investment prospects, and (4) investor ability to borrow at the same rate as corporations.

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 565

interest means the cost of debt, ri, to the firm is subsidized by the government. Letting rd equal the before-tax cost of debt and letting T equal the tax rate, from Chapter 11 (Equation 11.2), we have ri � rd � (1�T).

Probability of Bankruptcy

The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk.

Business Risk In Chapter 11, we defined business risk as the risk to the firm of being unable to cover its operating costs. In general, the greater the firm’s operating leverage—the use of fixed operating costs—the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors—revenue stability and cost stability—also affect it. Revenue stability reflects the relative variability of the firm’s sales revenues. Firms with reasonably stable levels of demand and with products that have stable prices have stable rev- enues. The result is low levels of business risk. Firms with highly volatile product demand and prices have unstable revenues that result in high levels of business risk. Cost stability reflects the relative predictability of input prices such as those for labor and materials. The more predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the higher the business risk.

Business risk varies among firms, regardless of their lines of business, and is not affected by capital structure decisions. The level of business risk must be taken as a “given.” The higher a firm’s business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk there- fore tend toward less highly leveraged capital structures, and firms with low busi- ness risk tend toward more highly leveraged capital structures. We will hold business risk constant throughout the discussions that follow.

Cooke Company, a soft drink manufacturer, is preparing to make a capital struc- ture decision. It has obtained estimates of sales and the associated levels of earn- ings before interest and taxes (EBIT) from its forecasting group: There is a 25% chance that sales will total $400,000, a 50% chance that sales will total $600,000, and a 25% chance that sales will total $800,000. Fixed operating costs total $200,000, and variable operating costs equal 50% of sales. These data are summarized, and the resulting EBIT calculated, in Table 12.9.

Example

Sales and Associated EBIT Calculations for Cooke Company ($000)

Probability of sales .25 .50 .25

Sales revenue $400 $600 $800

Less: Fixed operating costs 200 200 200

Less: Variable operating costs (50% of sales)

Earnings before interest and taxes (EBIT) $200$100$ 0

400300200

TABLE 12 .9

IS B

N : 0

-5 58

-0 20

09 -7

566 PART FOUR Long-Term Financial Decisions

The table shows that there is a 25% chance that the EBIT will be $0, a 50% chance that it will be $100,000, and a 25% chance that it will be $200,000. When developing the firm’s capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firm’s operating leverage, sales revenue variability, and cost predictability.

Financial Risk The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obliga- tions. The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost financing—debt (including financial leases) and preferred stock—a firm has in its capital structure, the greater its financial leverage and risk. Financial risk depends on the capital structure decision made by the manage- ment, and that decision is affected by the business risk the firm faces.

Total Risk The total risk of a firm—business and financial risk combined— determines its probability of bankruptcy. Financial risk, its relationship to busi- ness risk, and their combined impact can be demonstrated by continuing the Cooke Company example.

Cooke Company’s current capital structure is as follows:

Let us assume that the firm is considering seven alternative capital structures. If we measure these structures using the debt ratio, they are associated with ratios of 0%, 10%, 20%, 30%, 40%, 50%, and 60%. Assuming that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity as shown, and (3) the total amount of capital remains constant16 at $500,000, the mix of debt and equity associated with the seven debt ratios would be as shown in Table 12.10. Also shown in the table is the number of shares of common stock outstanding under each alternative.

Associated with each of the debt levels in column 3 of Table 12.10 would be an interest rate that would be expected to increase with increases in financial leverage. The level of debt, the associated interest rate (assumed to apply to all debt), and the dollar amount of annual interest associated with each of the alter- native capital structures are summarized in Table 12.11. Because both the level of debt and the interest rate increase with increasing financial leverage (debt ratios), the annual interest increases as well.

Example

Current capital structure

Long-term debt $ 0

Common stock equity (25,000 shares at $20)

Total capital (assets) $500,000

500,000

16. This assumption is needed so that we can assess alternative capital structures without having to consider the returns associated with the investment of additional funds raised. Attention here is given only to the mix of capital, not to its investment.

Hint As you learned in Chapter 2, the debt ratio is equal to the amount of total debt divided by the total assets. The higher this ratio, the more financial leverage a firm is using.

Hint The cash flows to investors from bonds are less risky than the dividends from preferred stock, which are ess risky than dividends from common stock. Only with bonds is the issuer contractually obligated to pay the scheduled interest, and the amounts due to bondholders and preferred stockholders are usually fixed. Therefore, the required return for bonds is generally lower than that for preferred stock, which is lower than that for common stock.

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 567

Table 12.12 on page 568 uses the levels of EBIT and associated probabilities developed in Table 12.9, the number of shares of common stock found in column 5 of Table 12.10, and the annual interest values calculated in column 3 of Table 12.11 to calculate the earnings per share (EPS) for debt ratios of 0%, 30%, and 60%. A 40% tax rate is assumed. Also shown are the resulting expected EPS, the standard deviation of EPS, and the coefficient of variation of EPS associated with each debt ratio.17

17. For explanatory convenience, the coefficient of variation of EPS, which measures total (nondiversifiable and diversifiable) risk, is used throughout this chapter as a proxy for beta, which measures the relevant nondiversi- fiable risk.

Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Company’s Alternative Capital Structures

Interest rate Interest ($000) Capital structure Debt ($000) on all debt [(1)� (2)]

debt ratio (1) (2) (3)

0% $ 0 0.0% $ 0.00

10 50 9.0 4.50

20 100 9.5 9.50

30 150 10.0 15.00

40 200 11.0 22.00

50 250 13.5 33.75

60 300 16.5 49.50

TABLE 12 .11

Capital Structures Associated with Alternative Debt Ratios for Cooke Company

Capital structure ($000) Shares of common

Debt Equity stock outstanding (000)

Debt ratio Total assetsa [(1)� (2)] [(2)� (3)] [(4)�$20]b

(1) (2) (3) (4) (5)

0% $500 $ 0 $500 25.00

10 500 50 450 22.50

20 500 100 400 20.00

30 500 150 350 17.50

40 500 200 300 15.00

50 500 250 250 12.50

60 500 300 200 10.00

aBecause the firm, for convenience, is assumed to have no current liabilities, its total assets equal its total capital of $500,000. bThe $20 value represents the book value per share of common stock equity noted earlier.

TABLE 12 .10

IS B

N : 0

-5 58

-0 20

09 -7

568 PART FOUR Long-Term Financial Decisions

Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company

Probability of EBIT .25 .50 .25

Debt ratio�0%

EBIT (Table 12.9) $ 0.00 $100.00 $200.00

Less: Interest (Table 12.11)

Net profits before taxes $ 0.00 $100.00 $200.00

Less: Taxes (T�0.40)

Net profits after taxes $ 0.00 $ 60.00 $120.00

EPS (25.0 shares, Table 12.10)

Expected EPSa $ 2.40

Standard deviation of EPSa $ 1.70

Coefficient of variation of EPSa 0.71

Debt ratio�30%

EBIT (Table 12.9) $ 0.00 $100.00 $200.00

Less: Interest (Table 12.11)

Net profits before taxes ($15.00) $ 85.00 $185.00

Less: Taxes (T�0.40) ( )b

Net profits after taxes ($ 9.00) $ 51.00 $111.00

EPS (17.50 shares, Table 12.10) ( )

Expected EPSa $ 2.91

Standard deviation of EPSa $ 2.42

Coefficient of variation of EPSa 0.83

Debt ratio�60%

EBIT (Table 12.9) $ 0.00 $100.00 $200.00

Less: Interest (Table 12.11)

Net profits before taxes ($49.50) $ 50.50 $150.50

Less: Taxes (T�0.40) ( )b

Net profits after taxes ($29.70) $ 30.30 $ 90.30

EPS (10.00 shares, Table 12.10) ( )

Expected EPSa $ 3.03

Standard deviation of EPSa $ 4.24

Coefficient of variation of EPSa 1.40

aThe procedures used to calculate the expected value, standard deviation, and coefficient of variation were presented in Equations 5.2, 5.3, and 5.4, respectively, in Chapter 5. bIt is assumed that the firm receives the tax benefit from its loss in the current period as a result of applying the tax loss carryback procedures specified in the tax law but not discussed in this text.

$ 9.03$ 3.03$ 2.97

60.2020.2019.80

49.5049.5049.50

$ 6.34$ 2.91$ 0.51

74.0034.006.00

15.0015.0015.00

$ 4.80$ 2.40$ 0.00

80.0040.000.00

0.000.000.00

TABLE 12 .12

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 569

Table 12.13 summarizes the pertinent data for the seven alternative capital structures. The values shown for 0%, 30%, and 60% debt ratios were developed in Table 12.12, whereas calculations of similar values for the other debt ratios (10%, 20%, 40%, and 50%) are not shown. Because the coefficient of variation measures the risk relative to the expected EPS, it is the preferred risk measure for use in comparing capital structures. As the firm’s financial leverage increases, so does its coefficient of variation of EPS. As expected, an increasing level of risk is associated with increased levels of financial leverage.

The relative risks of the two extremes of the capital structures evaluated in Table 12.12 (debt ratios�0% and 60%) can be illustrated by showing the prob- ability distribution of EPS associated with each of them. Figure 12.3 shows these two distributions. The expected level of EPS increases with increasing financial

0–1–2–3–4 1 2 3

3.032.40

4 5 6 7 8 9

EPS ($)

Debt Ratio = 0%

Debt Ratio = 60%

Probability Density

F IGURE 12 .3

Probability Distributions Probability distributions of EPS for debt ratios of 0% and 60% for Cooke Company

Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative Capital Structures for Cooke Company

Coefficient of Standard deviation variation of EPS

Capital structure Expected EPS of EPS [(2)� (1)] debt ratio (1) (2) (3)

0% $2.40 $1.70 0.71

10 2.55 1.88 0.74

20 2.72 2.13 0.78

30 2.91 2.42 0.83

40 3.12 2.83 0.91

50 3.18 3.39 1.07

60 3.03 4.24 1.40

TABLE 12 .13

IS B

N : 0

-5 58

-0 20

09 -7

570 PART FOUR Long-Term Financial Decisions

leverage, and so does risk, as reflected in the relative dispersion of each of the dis- tributions. Clearly, the uncertainty of the expected EPS, as well as the chance of experiencing negative EPS, is greater when higher degrees of financial leverage are employed.

Further, the nature of the risk–return tradeoff associated with the seven capital structures under consideration can be clearly observed by plotting the expected EPS and coefficient of variation relative to the debt ratio. Plotting the data from Table 12.13 results in Figure 12.4. The figure shows that as debt is substituted for equity (as the debt ratio increases), the level of EPS rises and then begins to fall (graph a). The graph demonstrates that the peak earnings per share occurs at a debt ratio of 50%. The decline in earnings per share beyond that ratio results from the fact that the significant increases in interest are not fully offset by the reduction in the number of shares of common stock outstanding.

If we look at the risk behavior as measured by the coefficient of variation (graph b), we can see that risk increases with increasing leverage. A portion of the risk can be attributed to business risk, but the portion that changes in response to increasing financial leverage would be attributed to financial risk.

Clearly, a risk–return tradeoff exists relative to the use of financial leverage. Later in the chapter we will address how to combine these risk–return factors into a valuation framework. The key point to recognize here is that as a firm introduces more leverage into its capital structure, it will typically experience increases in both the expected level of return and the associated risk.

Agency Costs Imposed by Lenders

As noted in Chapter 1, the managers of firms typically act as agents of the owners (stockholders). The owners give the managers the authority to manage the firm for the owners’ benefit. The agency problem created by this relationship extends not only to the relationship between owners and managers but also to the rela- tionship between owners and lenders.

When a lender provides funds to a firm, the interest rate charged is based on the lender’s assessment of the firm’s risk. The lender–borrower relationship, therefore, depends on the lender’s expectations for the firm’s subsequent behavior.

3.50

3.00 3.18

2.50

2.00 0.50

0.75

1.00

1.25

1.50

Ex p ec

te d E

P S

($ )

C o ef

fi ci

en t

o f

V a ri

a ti o n o

f EP

10 20 30 40 50 60 1000 20 30 40 50 60 70 80

Financial Risk

Business Risk

Debt Ratio (%) (b)

Debt Ratio (%) (a)

Maximum EPS

F IGURE 12 .4

Expected EPS and Coefficient of Variation of EPS Expected EPS and coefficient of variation of EPS for alternative capital structures for Cooke Company

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 571

The borrowing rates are, in effect, locked in when the loans are negotiated. After obtaining a loan at a certain rate, the firm could increase its risk by investing in risky projects or by incurring additional debt. Such action could weaken the lender’s position in terms of its claim on the cash flow of the firm. From another point of view, if these risky investment strategies paid off, the stockholders would benefit. Because payment obligations to the lender remain unchanged, the excess cash flows generated by a positive outcome from the riskier action would enhance the value of the firm to its owners. In other words, if the risky investments pay off, the owners receive all the benefits; if the risky investments do not pay off, the lenders share in the costs.

Clearly, an incentive exists for the managers acting on behalf of the stock- holders to “take advantage” of lenders. To avoid this situation, lenders impose certain monitoring techniques on borrowers, who as a result incur agency costs. The most obvious strategy is to deny subsequent loan requests or to increase the cost of future loans to the firm. But this strategy is an after-the-fact approach. Therefore, lenders typically protect themselves by including in the loan agreement provisions that limit the firm’s ability to alter significantly its business and finan- cial risk. These loan provisions tend to center on issues such as the minimum level of liquidity, asset acquisitions, executive salaries, and dividend payments.

By including appropriate provisions in the loan agreement, the lender can control the firm’s risk and thus protect itself against the adverse consequences of this agency problem. Of course, in exchange for incurring agency costs by agreeing to the operating and financial constraints placed on it by the loan provi- sions, the firm should benefit by obtaining funds at a lower cost.

Asymmetric Information

Two surveys examined capital structure decisions.18 Financial executives were asked which of two major criteria determined their financing decisions: (1) main- taining a target capital structure or (2) following a hierarchy of financing. This hierarchy, called a pecking order, begins with retained earnings, which is fol- lowed by debt financing and finally external equity financing. Respondents from 31 percent of Fortune 500 firms and from 11 percent of the (smaller) 500 largest over-the-counter firms answered target capital structure. Respondents from 69 percent of the Fortune 500 firms and 89 percent of the 500 largest OTC firms chose the pecking order.

At first glance, on the basis of financial theory, this choice appears to be inconsistent with wealth maximization goals, but Stewart Myers has explained how “asymmetric information” could account for the pecking order financing preferences of financial managers.19 Asymmetric information results when man- agers of a firm have more information about operations and future prospects than do investors. Assuming that managers make decisions with the goal of max- imizing the wealth of existing stockholders, then asymmetric information can affect the capital structure decisions that managers make.

18. The results of the survey of Fortune 500 firms are reported in J. Michael Pinegar and Lisa Wilbricht, “What Managers Think of Capital Structure Theory: A Survey,” Financial Management (Winter 1989), pp. 82–91, and the results of a similar survey of the 500 largest OTC firms are reported in Linda C. Hittle, Kamal Haddad, and Lawrence J. Gitman, “Over-the-Counter Firms, Asymmetric Information, and Financing Preferences,” Review of Financial Economics (Fall 1992), pp. 81–92.

19. Stewart C. Myers, “The Capital Structure Puzzle,” Journal of Finance (July 1984), pp. 575–592.

Hint Typical loan provisions included in corporate bonds are discussed in Chapter 6.

pecking order A hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing.

asymmetric information The situation in which managers of a firm have more information about operations and future prospects than do investors.

IS B

N : 0

-5 58

-0 20

09 -7

572 PART FOUR Long-Term Financial Decisions

Suppose, for example, that management has found a valuable investment that will require additional financing. Management believes that the prospects for the firm’s future are very good and that the market, as indicated by the firm’s cur- rent stock price, does not fully appreciate the firm’s value. In this case, it would be advantageous to current stockholders if management raised the required funds using debt rather than issuing new stock. Using debt to raise funds is frequently viewed as a signal that reflects management’s view of the firm’s stock value. Debt financing is a positive signal suggesting that management believes that the stock is “undervalued” and therefore a bargain. When the firm’s positive future out- look becomes known to the market, the increased value will be fully captured by existing owners, rather than having to be shared with new stockholders.

If, however, the outlook for the firm is poor, management may believe that the firm’s stock is “overvalued.” In that case, it would be in the best interest of existing stockholders for the firm to issue new stock. Therefore, investors often interpret the announcement of a stock issue as a negative signal—bad news con- cerning the firm’s prospects—and the stock price declines. This decrease in stock value, along with high underwriting costs for stock issues (compared to debt issues), make new stock financing very expensive. When the negative future out- look becomes known to the market, the decreased value is shared with new stockholders, rather than being fully captured by existing owners.

Because conditions of asymmetric information exist from time to time, firms should maintain some reserve borrowing capacity by keeping debt levels low. This reserve allows the firm to take advantage of good investment opportunities without having to sell stock at a low value and thus send signals that unduly influence the stock price.

Optimal Capital Structure

What, then, is the optimal capital structure, even if it exists (so far) only in theory? To provide some insight into an answer, we will examine some basic financial relationships. It is generally believed that the value of the firm is maxi- mized when the cost of capital is minimized. By using a modification of the simple zero-growth valuation model (see Equation 7.3 in Chapter 7), we can define the value of the firm, V, by Equation 12.11.

(12.11)

where

EBIT�earnings before interest and taxes

T� tax rate

NOPAT�net operating profits after taxes, which (as noted in Chapters 3 and 8) is the after-tax operating earnings available to the debt and equity holders, EBIT� (1�T)

ra �weighted average cost of capital

Clearly, if we assume that NOPAT (and therefore EBIT) is constant, the value of the firm, V, is maximized by minimizing the weighted average cost of capital, ra.

V 5 EBIT 3 (1 2 T)

ra 5

NOPAT ra

signal A financing action by management that is believed to reflect its view of the firm’s stock value; generally, debt financing is viewed as a positive signal that management believes the stock is “undervalued,” and a stock issue is viewed as a negative signal that management believes the stock is “overvalued.”

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 573

Cost Functions

Figure 12.5(a) plots three cost functions—the cost of debt, the cost of equity, and the weighted average cost of capital (WACC)—as a function of financial leverage measured by the debt ratio (debt to total assets). The cost of debt, ri , remains low because of the tax shield, but it slowly increases as leverage increases, to compen- sate lenders for increasing risk. The cost of equity, rs, is above the cost of debt. It increases as financial leverage increases, but it generally increases more rapidly than the cost of debt. The cost of equity rises because the stockholders require a higher return as leverage increases, to compensate for the higher degree of finan- cial risk.

The weighted average cost of capital, ra (WACC) results from a weighted average of the firm’s debt and equity capital costs. At a debt ratio of zero, the firm is 100 percent equity-financed. As debt is substituted for equity and as the debt ratio increases, the WACC declines because the debt cost is less than the equity cost (ri � rs). As the debt ratio continues to increase, the increased debt and equity costs eventually cause the WACC to rise (after point M in Figure 12.5(a)). This behavior results in a U-shaped, or saucer-shaped, weighted average cost-of- capital function, ra.

Graphical View of Optimal Structure

Because the maximization of value, V, is achieved when the overall cost of cap- ital, ra, is at a minimum (see Equation 12.11), the optimal capital structure is that at which the weighted average cost of capital, ra, is minimized. In Figure 12.5(a), point M represents the minimum weighted average cost of capital—the point of optimal financial leverage and hence of optimal capital structure for the firm.

A n n u a l C o st

( %

) V

a lu

M = Optimal Capital Structure

Debt/Total Assets0

V = NOPAT

rs = cost of equity

ra = WACC ri = cost of debt

Financial Leverage

(a)

(b)

F IGURE 12 .5

Cost Functions and Value Capital costs and the optimal capital structure

optimal capital structure The capital structure at which the weighted average cost of capital is minimized, thereby maximizing the firm’s value.

IS B

N : 0

-5 58

-0 20

09 -7

Figure 12.5(b) plots the value of the firm that results from substitution of ra in Figure 12.5(a) for various levels of financial leverage into the zero-growth valua- tion model in Equation 12.11. As shown in Figure 12.5(b), at the optimal capital structure, point M, the value of the firm is maximized at V*.

Generally, the lower the firm’s weighted average cost of capital, the greater the difference between the return on a project and the WACC, and therefore the greater the owners’ return. Simply stated, minimizing the weighted average cost of capital allows management to undertake a larger number of profitable proj- ects, thereby further increasing the value of the firm.

As a practical matter, there is no way to calculate the optimal capital struc- ture implied by Figure 12.5. Because it is impossible either to know or to remain at the precise optimal capital structure, firms generally try to operate in a range that places them near what they believe to be the optimal capital structure.

REVIEW QUESTIONS

12–6 What is a firm’s capital structure? What ratios assess the degree of financial leverage in a firm’s capital structure?

12–7 In what ways are the capital structures of U.S. and non-U.S. firms dif- ferent? How are they similar?

12–8 What is the major benefit of debt financing? How does it affect the firm’s cost of debt?

12–9 What are business risk and financial risk? How does each of them influ- ence the firm’s capital structure decisions?

12–10 Briefly describe the agency problem that exists between owners and lenders. How do lenders cause firms to incur agency costs to resolve this problem?

12–11 How does asymmetric information affect the firm’s capital structure decisions? How do the firm’s financing actions give investors signals that reflect management’s view of stock value?

12–12 How do the cost of debt, the cost of equity, and the weighted average cost of capital (WACC) behave as the firm’s financial leverage increases from zero? Where is the optimal capital structure? What is its relation- ship to the firm’s value at that point?

12.3 EBIT–EPS Approach to Capital Structure

It should be clear from earlier chapters that the goal of the financial manager is to maximize owner wealth—that is, the firm’s stock price. One of the widely fol- lowed variables affecting the firm’s stock price is its earnings, which represents the returns earned on behalf of owners. In spite of the fact that focusing on earn- ings ignores risk (the other key variable affecting the firm’s stock price), earnings per share (EPS) can be conveniently used to analyze alternative capital structures. The EBIT–EPS approach to capital structure involves selecting the capital struc- ture that maximizes EPS over the expected range of earnings before interest and taxes (EBIT).

LG 5

574 PART FOUR Long-Term Financial Decisions

EBIT–EPS approach An approach for selecting the capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT).

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 575

Presenting a Financing Plan Graphically

To analyze the effects of a firm’s capital structure on the owners’ returns, we con- sider the relationship between earnings before interest and taxes (EBIT) and earn- ings per share (EPS). A constant level of EBIT—constant business risk—is assumed, to isolate the effect on returns of the financing costs associated with alternative capital structures. EPS is used to measure the owners’ returns, which are expected to be closely related to share price.20

Data Required

To graph a financing plan, we need to know at least two EBIT–EPS coordinates. The following example illustrates the approach for obtaining coordinates.

EBIT–EPS coordinates can be found by assuming specific EBIT values and calcu- lating the EPS associated with them.21 Such calculations for three capital struc- tures—debt ratios of 0%, 30%, and 60%—for Cooke Company were presented in Table 12.12. For EBIT values of $100,000 and $200,000, the associated EPS values calculated there are summarized in the table below the graph in Fig- ure 12.6 on page 576.

Plotting the Data

The Cooke Company data can be plotted on a set of EBIT–EPS axes, as shown in Figure 12.6. The figure shows the level of EPS expected for each level of EBIT. For levels of EBIT below the x-axis intercept, a loss (negative EPS) results. Each of the x-axis intercepts is a financial breakeven point, the level of EBIT necessary to just cover all fixed financial costs (EPS�$0).

Comparing Alternative Capital Structures

We can compare alternative capital structures by graphing financing plans as shown in Figure 12.6.

Cooke Company’s capital structure alternatives were plotted on the EBIT–EPS axes in Figure 12.6. This figure shows that each capital structure is superior to the others in terms of maximizing EPS over certain ranges of EBIT. The zero- leverage capital structure (debt ratio � 0%) is superior to either of the other

Example

financial breakeven point The level of EBIT necessary to just cover all fixed financial costs; the level of EBIT for which EPS � $0.

20. The relationship that is expected to exist between EPS and owner wealth is not one of cause and effect. As indi- cated in Chapter 1, the maximization of profits does not necessarily ensure that owners’ wealth is also maximized. Nevertheless, it is expected that the movement of earnings per share will have some effect on owners’ wealth, because EPS data constitute one of the few pieces of information investors receive, and they often bid the firm’s share price up or down in response to the level of these earnings.

21. A convenient method for finding one EBIT–EPS coordinate is to calculate the financial breakeven point, the level of EBIT for which the firm’s EPS just equals $0. It is the level of EBIT needed just to cover all fixed financial costs— annual interest (I) and preferred stock dividends (PD). The equation for the financial breakeven point is

Financial breakeven point� I�

where T is the tax rate. It can be seen that when PD � $0, the financial breakeven point is equal to I, the annual interest payment.

PD 1 2 T

IS B

N : 0

-5 58

-0 20

09 -7

576 PART FOUR Long-Term Financial Decisions

capital structures for levels of EBIT between $0 and $50,000. Between $50,000 and $95,500 of EBIT, the capital structure associated with a debt ratio of 30% is preferred. And at a level of EBIT above $95,500, the 60% debt ratio capital structure provides the highest earnings per share.22

Capital structure debt ratio

EBIT $100,000 $200,000 Earnings per share (EPS)

30 60

$2.40

2.91 3.03

$4.80

6.34 9.03

10 9 8 7 6 5 4 3 2 1 0

–1 30%

30%

60%

EBIT ($000)

50 100 95.50

150 200

–2 –3 –4

EP S

($ )

Debt Ratio

Debt Ratio Debt Ratio

= 60%

= 30%

= 0%

Financial Breakeven Points

F IGURE 12 .6

EBIT–EPS Approach A comparison of selected capital structures for Cooke Company (data from Table 12.12)

22. An algebraic technique can be used to find the indifference points between the capital structure alternatives. This technique involves expressing each capital structure as an equation stated in terms of earnings per share, setting the equations for two capital structures equal to each other, and solving for the level of EBIT that causes the equations to be equal. When we use the notation from footnote 21 and let n equal the number of shares of common stock out- standing, the general equation for the earnings per share from a financing plan is

Comparing Cooke Company’s 0% and 30% capital structures, we get

10.50�EBIT�15.00�EBIT�$225.00

$225.00�4.50�EBIT

EBIT�$50

The calculated value of the indifference point between the 0% and 30% capital structures is therefore $50,000, as can be seen in Figure 12.6.

0.60 3 EBIT 25.00

5 0.60 3 EBIT 2 $9.00

17.50

(1 2 0.40) 3 (EBIT 2 $0) 2 $0

25.00 5

(1 2 0.40) 3 (EBIT 2 $15.00) 2 $0

17.50

EPS 5 (1 2 T) 3 (EBIT 2 I) 2 PD

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 577

Considering Risk in EBIT–EPS Analysis

When interpreting EBIT–EPS analysis, it is important to consider the risk of each capital structure alternative. Graphically, the risk of each capital structure can be viewed in light of two measures: (1) the financial breakeven point (EBIT-axis intercept) and (2) the degree of financial leverage reflected in the slope of the cap- ital structure line: The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.23

Further assessment of risk can be performed by using ratios. As financial leverage (measured by the debt ratio) increases, we expect a corresponding decline in the firm’s ability to make scheduled interest payments (measured by the times interest earned ratio).

Reviewing the three capital structures plotted for Cooke Company in Figure 12.6, we can see that as the debt ratio increases, so does the financial risk of each alter- native. Both the financial breakeven point and the slope of the capital structure lines increase with increasing debt ratios. If we use the $100,000 EBIT value, for example, the times interest earned ratio (EBIT � interest) for the zero-leverage capital structure is infinity ($100,000 � $0); for the 30% debt case, it is 6.67 ($100,000�$15,000); and for the 60% debt case, it is 2.02 ($100,000�$49,500). Because lower times interest earned ratios reflect higher risk, these ratios support the conclusion that the risk of the capital structures increases with increasing financial leverage. The capital structure for a debt ratio of 60% is riskier than that for a debt ratio of 30%, which in turn is riskier than the capital structure for a debt ratio of 0%.

Basic Shortcoming of EBIT–EPS Analysis

The most important point to recognize when using EBIT–EPS analysis is that this technique tends to concentrate on maximizing earnings rather than maximizing owner wealth as reflected in the firm’s stock price. The use of an EPS-maximizing approach generally ignores risk. If investors did not require risk premiums (addi- tional returns) as the firm increased the proportion of debt in its capital structure, a strategy involving maximizing EPS would also maximize stock price. But because risk premiums increase with increases in financial leverage, the maximiza- tion of EPS does not ensure owner wealth maximization. To select the best capital structure, firms must integrate both return (EPS) and risk (via the required return, rs) into a valuation framework consistent with the capital structure theory pre- sented earlier.

REVIEW QUESTION

12–13 Explain the EBIT–EPS approach to capital structure. Include in your explanation a graph indicating the financial breakeven point; label the axes. Is this approach consistent with maximization of the owners’ wealth?

Example

23. The degree of financial leverage (DFL) is reflected in the slope of the EBIT–EPS function. The steeper the slope, the greater the degree of financial leverage, because the change in EPS (y axis) that results from a given change in EBIT (x axis) increases with increasing slope and decreases with decreasing slope.

IS B

N : 0

-5 58

-0 20

09 -7

578 PART FOUR Long-Term Financial Decisions

12.4 Choosing the Optimal Capital Structure

A wealth maximization framework for use in making capital structure decisions should include the two key factors of return and risk. This section describes the procedures for linking to market value the return and risk associated with alter- native capital structures.

Linkage

To determine the firm’s value under alternative capital structures, the firm must find the level of return that it must earn to compensate owners for the risk being incurred. This approach is consistent with the overall valuation framework developed in Chapters 6 and 7 and applied to capital budgeting decisions in Chapters 9 and 10.

The required return associated with a given level of financial risk can be esti- mated in a number of ways. Theoretically, the preferred approach would be first to estimate the beta associated with each alternative capital structure and then to use the CAPM framework presented in Equation 5.8 to calculate the required return, rs. A more operational approach involves linking the financial risk associ- ated with each capital structure alternative directly to the required return. Such an approach is similar to the CAPM-type approach demonstrated in Chapter 10 for linking project risk and required return (RADR). Here it involves estimating the required return associated with each level of financial risk, as measured by a statistic such as the coefficient of variation of EPS. Regardless of the approach used, one would expect the required return to increase as the financial risk increases.

Cooke Company, using as risk measures the coefficients of variation of EPS asso- ciated with each of the seven alternative capital structures, estimated the associ- ated required returns. These are shown in Table 12.14. As expected, the estimated required return of owners, rs, increases with increasing risk, as measured by the coefficient of variation of EPS.

Estimating Value

The value of the firm associated with alternative capital structures can be esti- mated by using one of the standard valuation models. If, for simplicity, we assume that all earnings are paid out as dividends, we can use a zero-growth valuation model such as that developed in Chapter 7. The model, originally stated in Equation 7.3, is restated here with EPS substituted for dividends (because in each year the dividends would equal EPS):

(12.12)

By substituting the expected level of EPS and the associated required return, rs, into Equation 12.12, we can estimate the per-share value of the firm, P0.

P0 5 EPS rs

Example

LG 6

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 579

We can now estimate the value of Cooke Company’s stock under each of the alternative capital structures. Substituting the expected EPS (column 1 of Table 12.13) and the required returns, rs (column 2 of Table 12.14 in decimal form), into Equation 12.12 for each of the capital structures, we obtain the share values given in column 3 of Table 12.15. Plotting the resulting share values against the associated debt ratios, as shown in Figure 12.7 on page 580, clearly illustrates that the maximum share value occurs at the capital structure associated with a debt ratio of 30%.

Maximizing Value versus Maximizing EPS

Throughout this text, we have specified the goal of the financial manager as max- imizing owner wealth, not profit. Although some relationship exists between expected profit and value, there is no reason to believe that profit-maximizing

Example

Calculation of Share Value Estimates Associated with Alternative Capital Structures for Cooke Company

Estimated Expected EPS required return, rs Estimated

(from column 1 (from column 2 share value Capital structure of Table 12.13) of Table 12.14) [(1)� (2)]

debt ratio (1) (2) (3)

0% $2.40 .115 $20.87

10 2.55 .117 21.79

20 2.72 .121 22.48

30 2.91 .125 23.28

40 3.12 .140 22.29

50 3.18 .165 19.27

60 3.03 .190 15.95

TABLE 12 .15

Required Returns for Cooke Company’s Alternative Capital Structures

Coefficient of variation of EPS (from column 3 Estimated required

Capital structure of Table 12.13) return, rs debt ratio (1) (2)

0% 0.71 11.5%

10 0.74 11.7

20 0.78 12.1

30 0.83 12.5

40 0.91 14.0

50 1.07 16.5

60 1.40 19.0

TABLE 12 .14

IS B

N : 0

-5 58

-0 20

09 -7

580 PART FOUR Long-Term Financial Decisions

strategies necessarily result in wealth maximization. It is therefore the wealth of the owners as reflected in the estimated share value that should serve as the crite- rion for selecting the best capital structure. A final look at Cooke Company will highlight this point.

Further analysis of Figure 12.7 clearly shows that although the firm’s profits (EPS) are maximized at a debt ratio of 50%, share value is maximized at a 30% debt ratio. Therefore, the preferred capital structure would be the 30% debt ratio. The two approaches provide different conclusions because EPS maximiza- tion does not consider risk.

Some Other Important Considerations

Because there is really no practical way to calculate the optimal capital structure, any quantitative analysis of capital structure must be tempered with other impor- tant considerations. Table 12.16 on page 581 summarizes some of the more important additional factors involved in capital structure decisions.

REVIEW QUESTIONS

12–14 Why do maximizing EPS and maximizing value not necessarily lead to the same conclusion about the optimal capital structure?

12–15 What important factors in addition to quantitative factors should a firm consider when it is making a capital structure decision?

Example

2.00 2.50 3.00 3.50

15.00

20.00

25.00

10 20 30 40 50 60 700 Maximum

Share Value Maximum

EPS Debt Ratio (%)

Es ti m

a te

d S

h a re

V a lu

e ($

) EP

S ($

)

EPS

Estimated Share Value

Maximum Share Value = $23.28

Maximum EPS = $3.18

F IGURE 12 .7

Estimating Value Estimated share value and EPS for alternative capital structures for Cooke Company

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 581

Summary

Focus on Value

The amount of leverage (fixed-cost assets or funds) employed by a firm directly affects its risk, return, and share value. Generally, higher leverage raises risk and return, and lower leverage reduces risk and return. Operating leverage concerns

Important Factors to Consider in Making Capital Structure Decisions

Concern Factor Description

Business risk Revenue stability Firms that have stable and predictable revenues can more safely undertake highly leveraged capital structures than can firms with volatile patterns of sales revenue. Firms with growing sales tend to benefit from added debt; they can reap the positive benefits of financial leverage, which magnifies the effect of these increases.

Cash flow When considering a new capital structure, the firm must focus on its ability to generate the cash flows necessary to meet obligations. Cash forecasts reflecting an ability to service debts (and preferred stock) must support any shift in capital structure.

Agency costs Contractual obligations A firm may be contractually constrained with respect to the type of funds that it can raise. For example, a firm might be prohibited from selling additional debt except when the claims of holders of such debt are made subordinate to the existing debt. Contractual constraints on the sale of additional stock, as well as on the ability to distribute dividends on stock, might also exist.

Management preferences Occasionally, a firm will impose an internal constraint on the use of debt to limit its risk exposure to a level deemed acceptable to management. In other words, because of risk aversion, the firm’s management constrains the firm’s capital structure at a level that may or may not be the true optimum.

Control A management group concerned about control may prefer to issue debt rather than (voting) common stock. Under favorable market conditions, a firm that wanted to sell equity could make a preemptive offering or issue nonvoting shares, allowing each shareholder to maintain proportionate ownership. Generally, only in closely held firms or firms threatened by takeover does control become a major concern in the capital structure decision.

Asymmetric information External risk assessment The firm’s ability to raise funds quickly and at favorable rates depends on the external risk assessments of lenders and bond raters. The firm must consider the impact of capital structure decisions both on share value and on published financial statements from which lenders and raters assess the firm’s risk.

Timing At times when interest rates are low, debt financing might be more attractive; when interest rates are high, the sale of stock may be more appealing. Sometimes both debt and equity capital become unavailable at reasonable terms. General economic conditions—especially those of the capital market—can thus significantly affect capital structure decisions.

TABLE 12 .16

IS B

N : 0

-5 58

-0 20

09 -7

582 PART FOUR Long-Term Financial Decisions

the level of fixed operating costs; financial leverage focuses on fixed financial costs, particularly interest on debt and any preferred stock dividends. The firm’s capital structure determines its financial leverage. Because of its fixed interest payments, the more debt a firm employs relative to its equity, the greater its financial leverage.

The value of the firm is clearly affected by its degree of operating leverage and by the composition of its capital structure. The financial manager must therefore carefully consider the types of operating and financial costs it incurs, recognizing that with greater fixed costs comes higher risk. Major decisions with regard to both operating cost structure and capital structure must therefore focus on their impact on the firm’s value. The firm should implement only those leverage and capital structure decisions that are consistent with its goal of maximizing its stock price.

Review of Learning Goals

Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on it. Leverage results from the use of fixed costs to magnify returns to a firm’s owners. Capital

structure, the firm’s mix of long-term debt and equity, affects leverage and there- fore the firm’s value. Breakeven analysis measures the level of sales necessary to cover total operating costs. The operating breakeven point may be calculated algebraically, by dividing fixed operating costs by the difference between the sale price per unit and variable operating cost per unit, or it may be determined graphically. The operating breakeven point increases with increased fixed and variable operating costs and decreases with an increase in sale price, and vice versa.

Understand operating, financial, and total leverage and the relationships among them. Operating leverage is the use of fixed operating costs by the firm to magnify the effects of changes in sales on EBIT. The higher the

fixed operating costs, the greater the operating leverage. Financial leverage is the use of fixed financial costs by the firm to magnify the effects of changes in EBIT on EPS. The higher the fixed financial costs, the greater the financial leverage. The total leverage of the firm is the use of fixed costs—both operating and financial—to magnify the effects of changes in sales on EPS.

Describe the types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory. Debt capital and equity capital make up a firm’s capital structure. Capital struc-

ture can be externally assessed by using financial ratios—debt ratio, times interest earned ratio, and fixed-payment coverage ratio. Non-U.S. companies tend to have much higher degrees of indebtedness than do their U.S. counter- parts, primarily because U.S. capital markets are more developed.

Research suggests that there is an optimal capital structure that balances the firm’s benefits and costs of debt financing. The major benefit of debt financing is the tax shield. The costs of debt financing include the probability of bankruptcy; agency costs imposed by lenders; and asymmetric information, which typically causes firms to raise funds in a pecking order so as to send positive signals to the market and thereby enhance shareholder wealth.

LG 3

LG 2

LG 1

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 583

Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero-growth valuation model. The zero- growth valuation model defines the firm’s value as its net operating profits

after taxes (NOPAT), or after-tax EBIT, divided by its weighted average cost of capital. Assuming that NOPAT is constant, the value of the firm is maximized by minimizing its weighted average cost of capital (WACC). The optimal capital structure minimizes the WACC. Graphically, the firm’s WACC exhibits a U-shape, whose minimum value defines the optimal capital structure that maxi- mizes owner wealth.

Discuss the EBIT–EPS approach to capital structure. The EBIT–EPS approach evaluates capital structures in light of the returns they provide the firm’s owners and their degree of financial risk. Under the EBIT–EPS

approach, the preferred capital structure is the one that is expected to provide maximum EPS over the firm’s expected range of EBIT. Graphically, this approach reflects risk in terms of the financial breakeven point and the slope of the capital structure line. The major shortcoming of EBIT–EPS analysis is that it concentrates on maximizing earnings (returns) rather than owners’ wealth, which considers risk as well as return.

Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital struc- ture. The best capital structure can be selected by using a valuation model

to link return and risk factors. The preferred capital structure is the one that results in the highest estimated share value, not the highest EPS. Other impor- tant nonquantitative factors must also be considered when making capital struc- ture decisions.

Self-Test Problems (Solutions in Appendix B) ST12–1 Breakeven point and all forms of leverage TOR most recently sold 100,000 units

at $7.50 each; its variable operating costs are $3.00 per unit, and its fixed operating costs are $250,000. Annual interest charges total $80,000, and the firm has 8,000 shares of $5 (annual dividend) preferred stock outstanding. It currently has 20,000 shares of common stock outstanding. Assume that the firm is subject to a 40% tax rate. a. At what level of sales (in units) would the firm break even on operations (that is,

EBIT�$0)? b. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the current

level of sales and (2) a 120,000-unit sales level. c. Using the current $750,000 level of sales as a base, calculate the firm’s degree of

operating leverage (DOL). d. Using the EBIT associated with the $750,000 level of sales as a base, calculate

the firm’s degree of financial leverage (DFL). e. Use the degree of total leverage (DTL) concept to determine the effect (in per-

centage terms) of a 50% increase in TOR’s sales from the $750,000 base level on its earnings per share.

LG 2

LG 1

LG 6

LG 5

LG 4

IS B

N : 0

-5 58

-0 20

09 -7

584 PART FOUR Long-Term Financial Decisions

ST12–2 EBIT–EPS analysis Newlin Electronics is considering additional financing of $10,000. It currently has $50,000 of 12% (annual interest) bonds and 10,000 shares of common stock outstanding. The firm can obtain the financing through a 12% (annual interest) bond issue or through the sale of 1,000 shares of common stock. The firm has a 40% tax rate. a. Calculate two EBIT–EPS coordinates for each plan by selecting any two EBIT

values and finding their associated EPS values. b. Plot the two financing plans on a set of EBIT–EPS axes. c. On the basis of your graph in part b, at what level of EBIT does the bond plan

become superior to the stock plan?

ST12–3 Optimal capital structure Hawaiian Macadamia Nut Company has collected the following data with respect to its capital structure, expected earnings per share, and required return.

a. Compute the estimated share value associated with each of the capital structures, using the simplified method described in this chapter (see Equation 12.12).

b. Determine the optimal capital structure on the basis of (1) maximization of expected earnings per share and (2) maximization of share value.

c. Which capital structure do you recommend? Why?

Warm-Up Exercises A blue box (■) indicates exercises available in . E12–1 Canvas Reproductions has fixed operating costs of $12,500, variable operating costs

of $10 per unit, and sells its paintings for $25 each. At what level of unit sales will the company breakeven in terms of EBIT?

E12–2 The Great Fish Taco Corporation currently has fixed operating costs of $15,000, sells its pre-made tacos for $6 per box, and incurs variable operating costs of $2.50 per box. If the firm has a potential investment that would simultaneously raise its fixed costs to $16,500 and allow it to charge a per-box sale price of $6.50 due to better- textured tacos, what will the impact be on its operating breakeven point in boxes?

E12–3 Chico’s has sales of 15,000 units at a price of $20 per unit. The firm incurs fixed operating costs of $30,000 and variable operating costs of $12 per unit. What is Chico’s degree of operating leverage (DOL) at a base level of sales of 15,000 units?

LG 2

LG 1

Capital structure Expected earnings Required debt ratio per share return, rs

0% $3.12 13%

10 3.90 15

20 4.80 16

30 5.44 17

40 5.51 19

50 5.00 20

60 4.40 22

LG 6

LG 3

LG 5

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 585

E12–4 Parker Investments has EBIT of $20,000, interest expense of $3,000, and preferred dividends of $4,000. If it pays taxes at a rate of 38%, what is Parker’s degree of financial leverage (DFL) at a base level of EBIT of $20,000?

E12–5 Cobalt Industries had sales of 150,000 units at a price of $10 per unit. It faced fixed operating costs of $250,000 and variable operating costs of $5 per unit. The com- pany is subject to a tax rate of 38% and has a weighted average cost of capital of 8.5%. Calculate Cobalt’s net operating profits after taxes (NOPAT), and use it to estimate the value of the firm.

Problems A blue box (■) indicates problems available in . P12–1 Breakeven point—Algebraic Kate Rowland wishes to estimate the number of

flower arrangements she must sell at $24.95 to break even. She has estimated fixed operating costs of $12,350 per year and variable operating costs of $15.45 per arrangement. How many flower arrangements must Kate sell to break even on operating costs?

P12–2 Breakeven comparisons—Algebraic Given the price and cost data shown in the accompanying table for each of the three firms, F, G, and H, answer the following questions.

a. What is the operating breakeven point in units for each firm? b. How would you rank these firms in terms of their risk?

P12–3 Breakeven point—Algebraic and graphical Fine Leather Enterprises sells its single product for $129.00 per unit. The firm’s fixed operating costs are $473,000 annu- ally, and its variable operating costs are $86.00 per unit. a. Find the firm’s operating breakeven point in units. b. Label the x axis “Sales (units)” and the y axis “Costs/Revenues ($),” and then

graph the firm’s sales revenue, total operating cost, and fixed operating cost functions on these axes. In addition, label the operating breakeven point and the areas of loss and profit (EBIT).

P12–4 Breakeven analysis Barry Carter is considering opening a music store. He wants to estimate the number of CDs he must sell to break even. The CDs will be sold for $13.98 each, variable operating costs are $10.48 per CD, and annual fixed operating costs are $73,500. a. Find the operating breakeven point in number of CDs. b. Calculate the total operating costs at the breakeven volume found in part a.

LG 1

Firm F G H

Sale price per unit $ 18.00 $ 21.00 $ 30.00

Variable operating cost per unit 6.75 13.50 12.00

Fixed operating cost 45,000 30,000 90,000

LG 1

LG 4

LG 2

IS B

N : 0

-5 58

-0 20

09 -7

586 PART FOUR Long-Term Financial Decisions

c. If Barry estimates that at a minimum he can sell 2,000 CDs per month, should he go into the music business?

d. How much EBIT will Barry realize if he sells the minimum 2,000 CDs per month noted in part c?

PERSONAL FINANCE PROBLEM

P12–5 Breakeven analysis Paul Scott has a 2008 Cadillac that he wants to update with a geo-tracker device so he will have access to road maps and directions. After-market equipment can be fitted for a flat fee of $500, and the service provider requires monthly charges of $20. In his line of work as a traveling salesman, he estimates that this device can save him time and money—about $35 per month (as the price of gas keeps increasing).

In order to determine the financial feasibility of purchasing the geo-tracker, Paul wants to determine the number of months it will take to break even. He plans to keep the car for another 3 years. a. Calculate the breakeven point for the device in months. b. Based on a, should Paul have the tracker installed in his car?

P12–6 Breakeven point—Changing costs/revenues JWG Company publishes Creative Crosswords. Last year the book of puzzles sold for $10 with variable operating cost per book of $8 and fixed operating costs of $40,000. How many books must JWG sell this year to achieve the breakeven point for the stated operating costs, given the following different circumstances? a. All figures remain the same as for last year. b. Fixed operating costs increase to $44,000; all other figures remain the same. c. The selling price increases to $10.50; all costs remain the same as for last year. d. Variable operating cost per book increases to $8.50; all other figures remain

the same. e. What conclusions about the operating breakeven point can be drawn from your

answers?

P12–7 Breakeven analysis Molly Jasper and her sister, Caitlin Peters, got into the novelties business almost by accident. Molly, a talented sculptor, often made little figurines as gifts for friends. Occasionally, she and Caitlin would set up a booth at a crafts fair and sell a few of the figurines along with jewelry that Caitlin made. Little by little, demand for the figurines, now called Mollycaits, grew, and the sisters began to reproduce some of the favorites in resin, using molds of the originals. The day came when a buyer for a major department store offered them a contract to produce 1,500 figurines of various designs for $10,000. Molly and Caitlin realized that it was time to get down to business. To make bookkeeping simpler, Molly had priced all of the figurines at $8.00. Variable operating costs amounted to an average of $6.00 per unit. To produce the order, Molly and Caitlin would have to rent indus- trial facilities for a month, which would cost them $4,000. a. Calculate Mollycaits’ operating breakeven point. b. Calculate Mollycaits’ EBIT on the department store order. c. If Molly renegotiates the contract at a price of $10.00 per figurine, what will the

EBIT be? d. If the store refuses to pay more than $8.00 per unit but is willing to negotiate

quantity, what quantity of figurines will result in an EBIT of $4,000?

LG 1

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 587

e. At this time, Mollycaits come in 15 different varieties. Whereas the average vari- able cost per unit is $6.00, the actual cost varies from unit to unit. What recom- mendation would you have for Molly and Caitlin with regard to pricing and/or the numbers and types of units that they offer for sale?

P12–8 EBIT sensitivity Stewart Industries sells its finished product for $9 per unit. Its fixed operating costs are $20,000, and the variable operating cost per unit is $5. a. Calculate the firm’s earnings before interest and taxes (EBIT) for sales of

10,000 units. b. Calculate the firm’s EBIT for sales of 8,000 and 12,000 units, respectively. c. Calculate the percentage changes in sales (from the 10,000-unit base level) and

associated percentage changes in EBIT for the shifts in sales indicated in part b. d. On the basis of your findings in part c, comment on the sensitivity of changes in

EBIT in response to changes in sales.

P12–9 Degree of operating leverage Grey Products has fixed operating costs of $380,000, variable operating costs of $16 per unit, and a selling price of $63.50 per unit. a. Calculate the operating breakeven point in units. b. Calculate the firm’s EBIT at 9,000, 10,000, and 11,000 units, respectively. c. With 10,000 units as a base, what are the percentage changes in units sold and

EBIT as sales move from the base to the other sales levels used in part b? d. Use the percentages computed in part c to determine the degree of operating

leverage (DOL). e. Use the formula for degree of operating leverage to determine the DOL at

10,000 units.

P12–10 Degree of operating leverage—Graphical Levin Corporation has fixed operating costs of $72,000, variable operating costs of $6.75 per unit, and a selling price of $9.75 per unit. a. Calculate the operating breakeven point in units. b. Compute the degree of operating leverage (DOL) using the following unit sales

levels as a base: 25,000, 30,000, 40,000. Use the formula given in the chapter. c. Graph the DOL figures that you computed in part b (on the y axis) against base

sales levels (on the x axis). d. Compute the degree of operating leverage at 24,000 units; add this point to

your graph. e. What principle do your graph and figures illustrate?

P12–11 EPS calculations Southland Industries has $60,000 of 16% (annual interest) bonds outstanding, 1,500 shares of preferred stock paying an annual dividend of $5 per share, and 4,000 shares of common stock outstanding. Assuming that the firm has a 40% tax rate, compute earnings per share (EPS) for the following levels of EBIT: a. $24,600 b. $30,600 c. $35,000

P12–12 Degree of financial leverage Northwestern Savings and Loan has a current capital structure consisting of $250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The firm pays taxes at the rate of 40%.

LG 2

IS B

N : 0

-5 58

-0 20

09 -7

588 PART FOUR Long-Term Financial Decisions

a. Using EBIT values of $80,000 and $120,000, determine the associated earnings per share (EPS).

b. Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL).

c. Rework parts a and b assuming that the firm has $100,000 of 16% (annual interest) debt and 3,000 shares of common stock.

PERSONAL FINANCE PROBLEM

P12–13 Financial leverage Max Small has outstanding school loans that require a monthly payment of $1,000. He needs to purchase a new car for work and estimates that this will add $350 per month to his existing monthly obligations. Max will have $3,000 available after meeting all of his monthly living (operating) expenses. This amount could vary by plus or minus 10%. a. In order to assess the potential impact of the additional borrowing on his

financial leverage, calculate the DFL in tabular form for both the current and proposed loan payments using Max’s available $3,000 as a base and a 10% change.

b. Can Max afford the additional loan payment? c. Should Max take on the additional loan payment?

P12–14 DFL and graphical display of financing plans Wells and Associates has EBIT of $67,500. Interest costs are $22,500, and the firm has 15,000 shares of common stock outstanding. Assume a 40% tax rate. a. Use the degree of financial leverage (DFL) formula to calculate the DFL for

the firm. b. Using a set of EBIT–EPS axes, plot Wells and Associates’ financing plan. c. If the firm also has 1,000 shares of preferred stock paying a $6.00 annual divi-

dend per share, what is the DFL? d. Plot the financing plan, including the 1,000 shares of $6.00 preferred stock,

on the axes used in part b. e. Briefly discuss the graph of the two financing plans.

P12–15 Integrative—Multiple leverage measures Play-More Toys produces inflatable beach balls, selling 400,000 balls per year. Each ball produced has a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs are $28,000. The firm has annual interest charges of $6,000, preferred dividends of $2,000, and a 40% tax rate. a. Calculate the operating breakeven point in units. b. Use the degree of operating leverage (DOL) formula to calculate DOL. c. Use the degree of financial leverage (DFL) formula to calculate DFL. d. Use the degree of total leverage (DTL) formula to calculate DTL. Compare this

to the product of DOL and DFL calculated in parts b and c.

P12–16 Integrative—Leverage and risk Firm R has sales of 100,000 units at $2.00 per unit, variable operating costs of $1.70 per unit, and fixed operating costs of $6,000. Interest is $10,000 per year. Firm W has sales of 100,000 units at $2.50 per unit, variable operating costs of $1.00 per unit, and fixed operating costs of $62,500. Interest is $17,500 per year. Assume that both firms are in the 40% tax bracket. a. Compute the degree of operating, financial, and total leverage for firm R. b. Compute the degree of operating, financial, and total leverage for firm W.

LG 2

LG 1

LG 5

LG 2

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 589

c. Compare the relative risks of the two firms. d. Discuss the principles of leverage that your answers illustrate.

P12–17 Integrative—Multiple leverage measures and prediction Carolina Fastener, Inc., makes a patented marine bulkhead latch that wholesales for $6.00. Each latch has variable operating costs of $3.50. Fixed operating costs are $50,000 per year. The firm pays $13,000 interest and preferred dividends of $7,000 per year. At this point, the firm is selling 30,000 latches per year and is taxed at a rate of 40%. a. Calculate Carolina Fastener’s operating breakeven point. b. On the basis of the firm’s current sales of 30,000 units per year and its interest and

preferred dividend costs, calculate its EBIT and earnings available for common. c. Calculate the firm’s degree of operating leverage (DOL). d. Calculate the firm’s degree of financial leverage (DFL). e. Calculate the firm’s degree of total leverage (DTL). f. Carolina Fastener has entered into a contract to produce and sell an additional

15,000 latches in the coming year. Use the DOL, DFL, and DTL to predict and calculate the changes in EBIT and earnings available for common. Check your work by a simple calculation of Carolina Fastener’s EBIT and earnings available for common, using the basic information given.

PERSONAL FINANCE PROBLEM

P12–18 Capital structure Kirsten Neal is interested in purchasing a new house given that mortgage rates are at a historical low. Her bank has specific rules regarding an appli- cant’s ability to meet the contractual payments associated with the requested debt. Kirsten must submit personal financial data for her income, expenses, and existing installment loan payments. The bank then calculates and compares certain ratios to predetermined allowable values to determine if it will make the requested loan. The requirements are as follows:

(1) Monthly mortgage payments � 28% of monthly gross (before-tax) income. (2) Total monthly installment payments (including the mortgage payments)

� 37% of monthly gross (before-tax) income.

Kirsten submits the following personal financial data:

a. Calculate the ratio for requirement 1. b. Calculate the ratio for requirement 2. c. Assuming that Kirsten has adequate funds for the down payment and meets

other lender requirements, will Kirsten be granted the loan?

P12–19 Various capital structures Charter Enterprises currently has $1 million in total assets and is totally equity-financed. It is contemplating a change in its capital struc- ture. Compute the amount of debt and equity that would be outstanding if the firm were to shift to each of the following debt ratios: 10%, 20%, 30%, 40%, 50%, 60%, and 90%. (Note: The amount of total assets would not change.) Is there a limit to the debt ratio’s value?

LG 3

Monthly gross (before-tax) income $4,500

Monthly installment loan obligations $375

Requested mortgage $150,000

Monthly mortgage payments $1,100

LG 3

LG 2

LG 1

IS B

N : 0

-5 58

-0 20

09 -7

590 PART FOUR Long-Term Financial Decisions

P12–20 Debt and financial risk Tower Interiors has made the forecast of sales shown in the following table. Also given is the probability of each level of sales.

The firm has fixed operating costs of $75,000 and variable operating costs equal to 70% of the sales level. The company pays $12,000 in interest per period. The tax rate is 40%. a. Compute the earnings before interest and taxes (EBIT) for each level of sales. b. Compute the earnings per share (EPS) for each level of sales, the expected EPS,

the standard deviation of the EPS, and the coefficient of variation of EPS, assuming that there are 10,000 shares of common stock outstanding.

c. Tower has the opportunity to reduce its leverage to zero and pay no interest. This will require that the number of shares outstanding be increased to 15,000. Repeat part b under this assumption.

d. Compare your findings in parts b and c, and comment on the effect of the reduc- tion of debt to zero on the firm’s financial risk.

P12–21 EPS and optimal debt ratio Williams Glassware has estimated, at various debt ratios, the expected earnings per share and the standard deviation of the earnings per share as shown in the following table.

a. Estimate the optimal debt ratio on the basis of the relationship between earnings per share and the debt ratio. You will probably find it helpful to graph the relationship.

b. Graph the relationship between the coefficient of variation and the debt ratio. Label the areas associated with business risk and financial risk.

P12–22 EBIT–EPS and capital structure Data-Check is considering two capital structures. The key information is shown in the following table. Assume a 40% tax rate.

Source of capital Structure A Structure B

Long-term debt $100,000 at 16% coupon rate $200,000 at 17% coupon rate

Common stock 4,000 shares 2,000 shares

LG 5

Debt ratio Earnings per share (EPS) Standard deviation of EPS

0% $2.30 $1.15

20 3.00 1.80

40 3.50 2.80

60 3.95 3.95

80 3.80 5.53

LG 4

Sales Probability

$200,000 .20

300,000 .60

400,000 .20

LG 3

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 591

a. Calculate two EBIT–EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Plot the two capital structures on a set of EBIT–EPS axes. c. Indicate over what EBIT range, if any, each structure is preferred. d. Discuss the leverage and risk aspects of each structure. e. If the firm is fairly certain that its EBIT will exceed $75,000, which structure

would you recommend? Why?

P12–23 EBIT–EPS and preferred stock Litho-Print is considering two possible capital structures, A and B, shown in the following table. Assume a 40% tax rate.

a. Calculate two EBIT–EPS coordinates for each of the structures by selecting any two EBIT values and finding their associated EPS values.

b. Graph the two capital structures on the same set of EBIT–EPS axes. c. Discuss the leverage and risk associated with each of the structures. d. Over what range of EBIT is each structure preferred? e. Which structure do you recommend if the firm expects its EBIT to be $35,000?

Explain.

P12–24 Integrative—Optimal capital structure Medallion Cooling Systems, Inc., has total assets of $10,000,000, EBIT of $2,000,000, and preferred dividends of $200,000 and is taxed at a rate of 40%. In an effort to determine the optimal capital structure, the firm has assembled data on the cost of debt, the number of shares of common stock for various levels of indebtedness, and the overall required return on investment:

a. Calculate earnings per share for each level of indebtedness. b. Use Equation 12.12 and the earnings per share calculated in part a to calculate

a price per share for each level of indebtedness. c. Choose the optimal capital structure. Justify your choice.

Capital structure No. of common debt ratio Cost of debt, rd stock shares Required return, rs

0% 0% 200,000 12%

15 8 170,000 13

30 9 140,000 14

45 12 110,000 16

60 15 80,000 20

LG 6

LG 4

LG 3

Source of capital Structure A Structure B

Long-term debt $75,000 at 16% $50,000 at 15% coupon rate coupon rate

Preferred stock $10,000 with an 18% $15,000 with an 18% annual dividend annual dividend

Common stock 8,000 shares 10,000 shares

LG 5

IS B

N : 0

-5 58

-0 20

09 -7

592 PART FOUR Long-Term Financial Decisions

P12–25 Integrative—Optimal capital structure Nelson Corporation has made the following forecast of sales, with the associated probabilities of occurrence noted.

The company has fixed operating costs of $100,000 per year, and variable operating costs represent 40% of sales. The existing capital structure consists of 25,000 shares of common stock that have a $10 per share book value. No other capital items are outstanding. The marketplace has assigned the following required returns to risky earnings per share.

The company is contemplating shifting its capital structure by substituting debt in the capital structure for common stock. The three different debt ratios under con- sideration are shown in the following table, along with an estimate, for each ratio, of the corresponding required interest rate on all debt.

The tax rate is 40%. The market value of the equity for a leveraged firm can be found by using the simplified method (see Equation 12.12). a. Calculate the expected earnings per share (EPS), the standard deviation of EPS,

and the coefficient of variation of EPS for the three proposed capital structures. b. Determine the optimal capital structure, assuming (1) maximization of earnings

per share and (2) maximization of share value. c. Construct a graph (similar to Figure 12.7) showing the relationships in part b.

(Note: You will probably have to sketch the lines, because you have only three data points.)

P12–26 Integrative—Optimal capital structure The board of directors of Morales Publishing, Inc., has commissioned a capital structure study. The company has total assets of $40,000,000. It has earnings before interest and taxes of $8,000,000 and is taxed at a rate of 40%.

LG 5

LG 4

LG 3

Debt Interest rate ratio on all debt

20% 10%

40 12

60 14

Coefficient of Estimated required variation of EPS return, rs

0.43 15%

0.47 16

0.51 17

0.56 18

0.60 22

0.64 24

Sales Probability

$200,000 .20

300,000 .60

400,000 .20

LG 6

LG 4

LG 3

LG 6

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 593

a. Create a spreadsheet like the one in Table 12.10 showing values of debt and equity as well as the total number of shares, assuming a book value of $25 per share.

b. Given the before-tax cost of debt at various levels of indebtedness, calculate the yearly interest expenses.

c. Using EBIT of $8,000,000, a 40% tax rate, and the information developed in parts a and b, calculate the most likely earnings per share for the firm at various levels of indebtedness. Mark the level of indebtedness that maximizes EPS.

Before-tax % Debt $ Total debt cost of debt, rd $ Interest expense

0% $_______ 0.0% $_______

10 _______ 7.5 _______

20 _______ 8.0 _______

30 _______ 9.0 _______

40 _______ 11.0 _______

50 _______ 12.5 _______

60 _______ 15.5 _______

% Debt Total assets $ Debt $ Equity No. of shares @ $25

0% $40,000,000 $_______ $_______ _______

10 40,000,000 _______ _______ _______

20 40,000,000 _______ _______ _______

30 40,000,000 _______ _______ _______

40 40,000,000 _______ _______ _______

50 40,000,000 _______ _______ _______

60 40,000,000 _______ _______ _______

Interest No. of % Debt EBIT expense EBT Taxes Net income shares EPS

0% $8,000,000 _______ _______ _______ _______ _______ _______

10 8,000,000 _______ _______ _______ _______ _______ _______

20 8,000,000 _______ _______ _______ _______ _______ _______

30 8,000,000 _______ _______ _______ _______ _______ _______

40 8,000,000 _______ _______ _______ _______ _______ _______

50 8,000,000 _______ _______ _______ _______ _______ _______

60 8,000,000 _______ _______ _______ _______ _______ _______

d. Using the EPS developed in part c, the estimates of required return, rs , and Equation 12.12, estimate the value per share at various levels of indebtedness. Mark the level of indebtedness in the table on page 594 that results in the max- imum price per share, P0.

IS B

N : 0

-5 58

-0 20

09 -7

594 PART FOUR Long-Term Financial Decisions

e. Prepare a recommendation to the board of directors of Morales Publishing that specifies the degree of indebtedness that will accomplish the firm’s goal of opti- mizing shareholder wealth. Use your findings in parts a through d to justify your recommendation.

P12–27 Integrative—Optimal capital structure Country Textiles, which has fixed operating costs of $300,000 and variable operating costs equal to 40% of sales, has made the following three sales estimates, with their probabilities noted.

The firm wishes to analyze five possible capital structures—0%, 15%, 30%, 45%, and 60% debt ratios. The firm’s total assets of $1 million are assumed to be con- stant. Its common stock has a book value of $25 per share, and the firm is in the 40% tax bracket. The following additional data have been gathered for use in ana- lyzing the five capital structures under consideration.

a. Calculate the level of EBIT associated with each of the three levels of sales. b. Calculate the amount of debt, the amount of equity, and the number of shares of

common stock outstanding for each of the five capital structures being considered. c. Calculate the annual interest on the debt under each of the five capital structures

being considered. (Note: The before-tax cost of debt, rd, is the interest rate appli- cable to all debt associated with the corresponding debt ratio.)

d. Calculate the EPS associated with each of the three levels of EBIT calculated in part a for each of the five capital structures being considered.

e. Calculate (1) the expected EPS, (2) the standard deviation of EPS, and (3) the coefficient of variation of EPS for each of the five capital structures, using your findings in part d.

Capital structure Before-tax cost Required debt ratio of debt, rd return, rs

0% 0.0% 10.0%

15 8.0 10.5

30 10.0 11.6

45 13.0 14.0

60 17.0 20.0

Sales Probability

$ 600,000 .30

900,000 .40

1,200,000 .30

LG 5

LG 4

LG 3

Debt EPS rs P0

0% _______ 10.0% _______

10 _______ 10.3 _______

20 _______ 10.9 _______

30 _______ 11.4 _______

40 _______ 12.6 _______

50 _______ 14.8 _______

60 _______ 17.5 _______

LG 6

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 595

f. Plot the expected EPS and coefficient of variation of EPS against the capital structures (x axis) on separate sets of axes, and comment on the return and risk relative to capital structure.

g. Using the EBIT–EPS data developed in part d, plot the 0%, 30%, and 60% cap- ital structures on the same set of EBIT–EPS axes, and discuss the ranges over which each is preferred. What is the major problem with the use of this approach?

h. Using the valuation model given in Equation 12.12 and your findings in part e, estimate the share value for each of the capital structures being considered.

i. Compare and contrast your findings in parts f and h. Which structure is pre- ferred if the goal is to maximize EPS? Which structure is preferred if the goal is to maximize share value? Which capital structure do you recommend? Explain.

P12–28 ETHICS PROBLEM “Information asymmetry lies at the heart of the ethical dilemma that managers, stockholders, and bondholders confront when companies initiate management buyouts or swap debt for equity.” Comment on this statement. What steps might a board of directors take to ensure that the company’s actions are ethical to all parties?

Chapter 12 Case

Evaluating Tampa Manufacturing’s Capital Structure

Tampa Manufacturing, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s board has instructed its management to insti- tute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value. In this regard, the firm’s chief financial officer (CFO), Jon Lawson, has been charged with evaluating the firm’s capital structure. Lawson believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital struc- ture, Lawson has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.

Capital structurea

Current A B Source of capital (10% debt) (30% debt) (50% debt)

Long-term debt $1,000,000 $3,000,000 $5,000,000

Coupon interest rateb 9% 10% 12%

Common stock 100,000 shares 70,000 shares 40,000 shares

Required return on equity, rsc 12% 13% 18%

aThese structures are based on maintaining the firm’s current level of $10,000,000 of total financing. bInterest rate applicable to all debt. cMarket-based return for the given level of risk.

LG 3

IS B

N : 0

-5 58

-0 20

09 -7

596 PART FOUR Long-Term Financial Decisions

Lawson expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

To Do a. Use the current level of EBIT to calculate the times interest earned ratio for each

capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.

b. Prepare a single EBIT–EPS graph showing the current and two alternative capital structures.

c. On the basis of the graph in part b, which capital structure will maximize Tampa’s earnings per share (EPS) at its expected level of EBIT of $1,200,000? Why might this not be the best capital structure?

d. Using the zero-growth valuation model given in Equation 12.12, find the market value of Tampa’s equity under each of the three capital structures at the $1,200,000 level of expected EBIT.

e. On the basis of your findings in parts c and d, which capital structure would you recommend? Why?

Spreadsheet Exercise Starstruck Company would like to determine its optimal capital structure. Several of its managers believe that the best method is to rely on the estimated earnings per share (EPS) of the firm, because they feel that profits and stock price are closely related. The financial managers have suggested another method that uses estimated required returns to estimate the share value of the firm. The following financial data are available.

To Do a. Based upon the given financial data, create a spreadsheet to calculate the esti-

mated share values associated with the seven alternative capital structures. Refer to Table 12.15 in the text (or view it at www.prenhall.com/gitman).

b. Use Excel to graph the relationship between capital structure and the estimated EPS of the firm. What is the optimal debt ratio? Refer to Figure 12.7 in the text (or view it at www.prenhall.com/gitman).

Capital structure Estimated Estimated debt ratio EPS required return

0% $1.75 11.40%

10 1.90 11.80

20 2.25 12.50

30 2.55 13.25

40 3.18 18.00

50 3.06 19.00

60 3.10 25.00

IS B

N : 0-558-02009-7

CHAPTER 12 Leverage and Capital Structure 597

c. Use Excel to graph the relationship between capital structure and the estimated share value of the firm. What is the optimal debt ratio? Refer to Figure 12.7 in the text (or view it at www.prenhall.com/gitman).

d. Do both methods lead to the same optimal capital structure? Which method do you favor? Explain.

e. What is the major difference between the EPS and share value methods?

Group Exercise This chapter continues the valuation process of the firm by investigating different types of leverage in conjunction with the capital structure. Here the analysis begins by bringing in the income statement to broaden the methodology introduced in Chap- ter 11. Your group will continue to combine data for your shadow and fictitious firm.

To Do a. Return to your shadow firm and view its most recent income statement. Identify

the important measures used in reporting leverage including EBIT and fixed and variable operating costs.

b. Use your shadow firm’s information to design a similar set of numbers for your fictitious firm. Assign a simple per-unit price for your product.

c. Calculate the operating breakeven point for your firm. Create a simple graph for sales revenue and total operating costs, highlighting the breakeven sales level in units.

d. Calculate the degree of operating leverage for your fictitious firm at a base sales level.

e. Return to your shadow firm and calculate its degree of financial leverage at its current levels of EBIT and EPS. Likewise, calculate your shadow firm’s degree of total leverage at current sales and EPS levels.

f. Use Equation 12.11 to value your shadow firm. Use estimates for your firm’s weighted average cost of capital. Do the same for your fictitious firm, using the numbers you assigned in Chapter 11’s exercise.

Web Exercise Go to the book’s companion website at www.prenhall.com/gitman to find the Web Exercise for this chapter.

Remember to check the book’s website at www.prenhall.com/gitman to find additional resources, including Web Exercises and a Web Case.

IS B

N : 0

-5 58

-0 20

09 -7

boom:

help: If you are experiencing problems unlocking this document or you have questions regarding Protectedpdf files please contact a Technical Support representative: In the United States: 1-877-832-4867 In Canada: 1-800-859-3682 Outside the U.S. and Canada: 1-602-387-2222 Email: [email protected].
protectedpdf_version:
abstract:
logo:
unlocked:

rememberme:
rememberme_label: Remember my user name and password.

title: Principles of Managerial Finance Ch12
version: 2013-01-21
form:

neversend:

pwd:

response:

docid: 1000-0001-2FAD-001093F0
username:

username_label: User Name:
pwd_label: Password:
login:

subtitle:
text:

instructions: This is a Protected PDF document. Please enter your user name and password to unlock the text.

info:

boom.info_publisher: This document is published by: Apollo Group, Inc.