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CHAPTER 11 and 14. LEVERAGE AND CAPITAL STRUCTURE. Business Risk and Financial Risk. Risk – the likely variability associated with expected revenue streams. The variations in the income stream can be attributed to: The firm’s exposure to business risk - PowerPoint PPT Presentation
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LEVERAGE AND CAPITAL STRUCTURE
• Risk – the likely variability associated with expected revenue streams.
• The variations in the income stream can be attributed to:
a. The firm’s exposure to business riskb. The firm’s decision to incur financial risk
• Business Risk – the risk that comes from the nature of the firm’s operating activities.
• Financial Risk – the risk that comes from the financial policy (i.e capital structure) of the firm.
2SITI AISHAH BINTI KASSIM (FM2)
• Financial Leverage – the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.
• Operating Leverage – the incurrence of fixed operating costs in the firm’s income stream.
3SITI AISHAH BINTI KASSIM (FM2)
• Objective – to determine the break-even quantity of output by studying the relationships among the firm’s cost structure, volume of output, and operating profit. • The break-even quantity of output results in an EBIT
level = 0• Some actual and potential applications of BEP include:
a. Capital expenditure analysis as a complementary technique to discounted cash flow evaluation models.
b. Pricing policyc. Labor contract negotiationsd. Evaluation of cost structuree. Financial decision making
4SITI AISHAH BINTI KASSIM (FM2)
• Essential elements of the break-even model:1. Fixed cost – cost that do not vary in total amount as the sales
volume or the quantity of output changes. Examples:a. Administrative salariesb. Depreciationc. Insurance premiumsd. Property taxese. Rent
2. Variable cost – cost that tend to vary in total as output changes. VC are fixed per unit of output. Examples:
a. Direct materialsb. Direct Laborc. Energy cost associated with productiond. Packaginge. Freight-outf. Sales commissions
5SITI AISHAH BINTI KASSIM (FM2)
3. Semivariables costs (Semifixed cost) – cost that exhibit the joint characteristics of both FC and VC over different ranges of output. Examples: Salaries paid to production supervisors.
6SITI AISHAH BINTI KASSIM (FM2)
• The break-even is just a simple adaptation of the firm’s income statement expressed as:– Profit (π) = Sales – (Total VC + Total FC)
• 3 ways to find BEP:a. Trial and Error
1) Select an arbitrary output level
2) Calculate the corresponding EBIT amount
3) When EBIT = 0, BEP has been found.
7SITI AISHAH BINTI KASSIM (FM2)
b. Contribution Margin Analysis1) Contribution Margin = Unit Selling Price – Unit VC2) BEP (units) = FC
contribution margin per unit
c. Algebraic Analysis1) QB = the break-even level of units
soldP = the unit sales priceF = the total FC for the periodV = unit VC
2) Then, QB = F
P – V 8SITI AISHAH BINTI KASSIM (FM2)
Example:
Mutiara Corporation (MC) manufactures a complete line of women’s dress. It sells each dress for RM 30. The variable cost for this dress is 70% of sales. Mutiara Corporation; incurs fixed costs of RM 360,000, how many dress must MC sell to breakeven?
9SITI AISHAH BINTI KASSIM (FM2)
Solutions:
*unit variable cost (VC) = 70% x RM 30 = RM 21
QB = F
P – V
= RM 360 000 = 40 000 unit
RM 30 – RM 21
10SITI AISHAH BINTI KASSIM (FM2)
• The BEP in sales dollars:– S* = F
1 – VC
S
Example: Sales $ 300 000
(-) Total VC 180 000
Revenue before FC 120 000
(-) Total FC 100 000
EBIT $ 20 000
11SITI AISHAH BINTI KASSIM (FM2)
Solutions:
S* = F = $ 100 0001 – VC 1 – $ 180 000
S $ 300 000
= $ 100 000
1 – 0.60
= $ 250 000
12SITI AISHAH BINTI KASSIM (FM2)
• Degree of Operating Leverage from the base = % change in EBIT sales level (DOLs) % change in Sales
• DOLs = Q (P – V) Q (P – V) – F
• DOLs = revenue before FC = S – VC EBIT S – VC – F
13SITI AISHAH BINTI KASSIM (FM2)
Example:Avitar Corporation manufactures a line of computer memory expansion boards used in microcomputers. The average selling price of its finished product is $175 per unit. The variable cost for these same units is $115. Avitar incurs fixed costs of $650,000 per year. Avitar estimates the sales in next year will be 20,000 units. What is Avitar expected degree of operating leverage?
14SITI AISHAH BINTI KASSIM (FM2)
Solutions:
DOLs = Q (P – V)
Q (P – V) – F
= 20 000 ($ 175 – $ 115)
[20 000 ($ 175 – $ 115)] – $ 650 000
= 2.1818 times15SITI AISHAH BINTI KASSIM (FM2)
• DFL = % change in EPS > 1
% change in EBIT
• DFLEBIT = EBIT
EBIT – I
* I = interest expense
16SITI AISHAH BINTI KASSIM (FM2)
Example:Sales $ 600,000
(-) total VC $ 200,000Revenue before FC $ 400,000
(-) total FC $ 200,000EBIT $ 200,000
(-) interest expenses $ 50,000EBT $ 150,000Taxes (34%) $ 51,000Net Income (EAT) $ 99,000
17SITI AISHAH BINTI KASSIM (FM2)
Solutions:What is the degree of financial leverage?
DFLEBIT = EBIT EBIT – I
= $ 200 000 $ 200 000 – $ 50 000
= 1.33 times
18SITI AISHAH BINTI KASSIM (FM2)
• DCL = % change in EPS
% change in Sales
• DCLs = (DOLs) x (DFLEBIT)
• DCLs = Q (P – V)
Q (P – V) – F – I
19SITI AISHAH BINTI KASSIM (FM2)
• Financial Structure – the mix of all funds source that appear on the right side of the balance sheet.
• Capital Structure – the mix of long term sources of funds used by the firm. Basically, this concept omits short-term liabilities.
• Financial Structure Design – the management activity of seeking the proper mix of all financing components in order to minimize the cost of raising a given of funds.
• Optimal Capital Structure – the unique capital structure that minimizes the firm’s composite cost of long term capital.
21SITI AISHAH BINTI KASSIM (FM2)
1. EBIT-EPS indifference point – the level of EBIT that will equate EPS between two difference financing plans.
EPS: Stock Plan EPS: Bond Plan
(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P
Ss Sb
* EBIT = earning before interest and taxes
I = interest expenses
t = firm income tax rate
P = preferred dividend paid
Ss = the number of common s/o under the stock plan
Sb = the number of common s/o under the bond plan
22SITI AISHAH BINTI KASSIM (FM2)
2. Projected Income StatementAlternative 1 Alternative 2
EBIT XXXXXX XXXXXX (-) Interest XXXXX XXXXX
EBT XXXXXX XXXXXX (-) Taxes XXXXX XXXXX
Net Income XXXXXX XXXXXXShares XXXXXXX XXXXXXXEPS* XXX XXX
*EPS = Net Income Shares Outstanding
23SITI AISHAH BINTI KASSIM (FM2)
Example:ING Berhad is financed entirely with 800,000 shares of common stock priced at RM 5 per unit and RM 1,000,000 worth of debt (8% 10 years bond). The company plans to raise an additional RM 2,000,000 to finance new project and considering two alternatives;
Alternative 1: 200,000 new common shares sold to the public
Alternative 2: Issue 10% bond
Projected level of EBIT is at approximately RM 2,000,000. Corporate tax rate is 28%.
24SITI AISHAH BINTI KASSIM (FM2)
Solutions:i. Calculate the indifference level of EBIT between two
alternatives.
* Plan Stock (alternative 1)
= Interest on bond = (1,000,000 x 8% = RM 80,000)
Unit shares = 800,000 + 200,000 = 1,000,000
*Plan Bond (alternative 2)
= Interest on bond = RM 80,000 + (RM 2,000,000 x 10% = RM 280,000)
Unit shares = 800,000
25SITI AISHAH BINTI KASSIM (FM2)
Plan Stock Plan Bond
(EBIT – I) (1 – t) – P = (EBIT – I) (1 – t) – P
Ss Sb
(EBIT – 80,000) (1 – 0.28) – 0 = (EBIT – 280,000) (1 – 0.28) - 0
1,000,000 800,000
0.72 EBIT – RM 57,600 = 0.72 EBIT – RM 201,600
1,000,000 800,000
576,000 EBIT – RM 46,080,000,000 = 720,000 EBIT – RM 201,600,000,000
– 144,000 EBIT = – RM 155,520,000,000
EBIT = RM 1,080,000
26SITI AISHAH BINTI KASSIM (FM2)
ii. Prepare the projected income statement that proves EPS will be the same regardless of the plan chosen at the EBIT level found in question (i)
Alternative 1 Alternative 2
EBIT RM 1,080,000 RM 1,080,000
(-) Interest 80,000 280,000
EBT 1,000,000 800,000
(-) Taxes (28%) 280,000 224,000
Net Income 720,000 576,000
Shares 1,000,000 800,000
EPS* 0.72 0.72
*EPS = Net Income
Shares Outstanding
27SITI AISHAH BINTI KASSIM (FM2)
iii. Which plan will provide the highest EPS for the EBIT projected level?
Alternative 1 Alternative 2
EBIT RM 2,000,000 RM 2,000,000
(-) Interest 80,000 280,000
EBT 1,920,000 1,720,000
(-) Taxes (28%) 537,600 481,600
Net Income 1,382,400 1,238,400
Shares 1,000,000 800,000
EPS* 1.3824 1.548
*EPS = Net Income
Shares Outstanding
28SITI AISHAH BINTI KASSIM (FM2)
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