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Copyright © 2003 Pearson Education, Inc. Slide 12-1
Ch 12 Learning Goals1. Operating, financial, and total leverage (causes &
measures).
2. Optimal capital structure.
3. The EBIT-EPS approach to capital structure.
Copyright © 2003 Pearson Education, Inc. Slide 12-2
Leverage
• A given percentage change in sales revenue
often causes a bigger percentage change in
earnings.
– Cause: ______________ costs
– Name: “_________________”
Copyright © 2003 Pearson Education, Inc. Slide 12-3
Leverage
• Kinds of leverage (& their causes):– Operating leverage (fixed________________
costs)– Financial leverage (fixed________________
costs)– Total leverage (the product of the other two)
Copyright © 2003 Pearson Education, Inc. Slide 12-4
Leverage
• Generally, higher leverage means:
– Increased ________________.
– Increased potential return.
Copyright © 2003 Pearson Education, Inc. Slide 12-6
Degree of Operating Leverage
• The degree of operating leverage (DOL) measures the
sensitivity of ________________ to changes in sales.
• DOL can be calculated by:
– Interval estimate
– point estimate
Operating Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-7
Interval Estimate of DOL
DOL = % Change in EBIT % Change in Sales
Operating Leverage
Degree of Operating Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-8
Point Estimate of DOL
DOL = Sales Rev - TVC Sales Rev - TVC - FC
Operating Leverage
Degree of Operating Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-10
Degree of Financial Leverage
• The degree of financial leverage (DFL) measures the
sensitivity of ______________ (or net profit after tax)
to changes in EBIT.
• Like the DOL, DFL can be calculated by:
– interval estimate
– point estimate
Financial Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-11
Interval Estimate of DFL
DFL = % Change in EPS % Change in EBIT
Financial Leverage
Degree of Financial Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-12
Point Estimate of DFL
DFL = EBIT EBIT - Interest
Financial LeverageDegree of Financial Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-13
• Total leverage can be viewed as the total impact of all
fixed costs in the firm’s operating and financial
structure.
Total Leverage
Copyright © 2003 Pearson Education, Inc. Slide 12-14
DTL = DOL x DFL
Total Leverage
Degree of Total Leverage
The relationship between the DTL, DOL, and
DFL is illustrated in the following equation:
Copyright © 2003 Pearson Education, Inc. Slide 12-15
Capital Structure Theory• There is an optimal, or target__________________
__________________ that will minimize a firm’s cost
of capital.
• The optimal capital structure balances the benefits of
debt financing against its costs.
• Unfortunately, it is difficult to identify what a firm’s
optimal capital structure is in practice.
Copyright © 2003 Pearson Education, Inc. Slide 12-16
Capital Structure Theory• The major benefit of debt financing is the ____
_____________ provided by the federal government regarding interest payments.
• The costs of debt financing include increased probability of bankruptcy caused by debt obligations
Copyright © 2003 Pearson Education, Inc. Slide 12-17
Capital Structure Theory
• The probability that debt obligations will lead to bankruptcy depends on a company’s business risk and financial risk.
• Business risk is the risk to the firm of being unable to
cover ____________________________________.
• High business risk is caused by– High fixed operating costs
– Unstable revenues and operating costs
Probability of Bankruptcy
Copyright © 2003 Pearson Education, Inc. Slide 12-18
Capital Structure Theory
• The firm’s capital structure is the mix of ___________
and _______________ it uses to finance fixed assets.
• The greater a firm’s use of debt financing, the greater
its financial leverage, and the greater its financial risk.
• Financial risk is the probability it cannot meet its
financial obligations.
Probability of Bankruptcy
Copyright © 2003 Pearson Education, Inc. Slide 12-19
The Optimal Capital StructureSo What is the Optimal Capital Structure?
• The market value of a company is maximized when
the cost of capital is _________________________.
Copyright © 2003 Pearson Education, Inc. Slide 12-20
Graphically
Kd
Ke
WACC
Cost (%)
TD/TA (%)0 Target
Capital Structure
Ke
Kd
The Optimal Capital Structure
Copyright © 2003 Pearson Education, Inc. Slide 12-21
GraphicallyFirmValue ($)
TD/TA (%)0 Target
Capital Structure
V($)
The Optimal Capital Structure
Copyright © 2003 Pearson Education, Inc. Slide 12-22
EPS-EBIT Approach to Capital Structure• The EPS-EBIT approach to analyzing capital structure
involves selecting the capital structure that maximizes
EPS over the expected range of EBIT.
• Shortcoming of this approach: it does not explicitly
consider the impact of _________________.