CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 13:

Capital Structure Management

INTRODUCTION

This chapter focuses on analytic tools to assist managers in making capital structure decisions that maximize shareholder wealth.

It also develops techniques for measuring operating and financial leverage.

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CONCEPT OF LEVERAGE Leverage, as the concept is used in finance, refers to the

ability to cause a large change in B, given a small change in A

In this Chapter, we discuss three types of leverage

Type of leverage Small change in Causes a big change in

Operating Sales EBIT

Financial EBIT EPS

Combined Sales EPS

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OPERATING LEVERAGE

The change in Earning Before Interest and Taxes (EBIT), given a change in sales revenue.

The Degree of Operating Leverage (DOL) is the percentage change in EBIT, given a 1% change in sales revenue

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FINANCIAL LEVERAGE

The change in Earnings Per Share (EPS), given a change in EBIT

The Degree of Financial Leverage (DFL) is the % change in EPS, given a 1% change in EBIT

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OPERATING AND FINANCIAL LEVERAGE

Operating and financial leverage arise due to the existence of fixed costs Fixed costs: costs that remain the same, independent of

volume Variable costs: costs that rise/fall with volume

Companies can switch the ratio between fixed and variable costs to maximize profits

Companies increase their leverage to enhance shareholder returns, but in doing so, they also increase risk 6

EXAMPLE: FIXED VERSUS VARIABLE COST

A company installs underground lawn sprinklers. The company must choose between laying pipe manually or buying a machine to lay the pipe.

If pipe laid manually and sales volume decreases, the company can lay off workers to reduce its costs.

If pipe laid by machine, company has a fixed cost of ownership that occurs whether the machine operates or not. If sales volume increases, the fixed cost of machine ownership remains the same, whereas the variable cost of labour will rise.

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COST VERSUS OUTPUT

8Output

Cost

Fixed Costs

Variab

le Cos

ts

Semi-variable Costs

LEVERAGE MODEL

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%Change in Sales

%Change in EBIT

%Change in EPS

DEGREE OF OPERATING LEVERAGE

Measured as the percentage change in earnings before interest and taxes (EBIT) resulting from a one percent change in sales

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Sales - Variable CostsDOL at X =

EBIT

EBIT = Sales - Variable Costs - Fixed Costs

∆ ∆ ÷ ÷ ÷ EBIT Sales

DOL at X = EBIT Sales

OPERATING LEVERAGE Must measure the Degree of Operating Leverage (DOL) at a

given level of sales, X

The DOL rises as EBIT approaches 0

The DOL rises as variable costs are replaced with fixed costs

When a variable cost is replaced with a fixed cost, the breakeven level of sales will increase

When a variable cost is replaced with a fixed cost, both profits and losses grow faster as sales rise and fall on either side of the breakeven point

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CONCEPT OF DOL

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Revenue

Total Cost

Fixed Cost

Quantity

Dollars

Breakeven Quantity

Low Fixed Costs with High Variable Costs

Low Breakeven; Profits/Losses Increase Slowly

Variable Cost

Profit

CONCEPT OF DOL

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Revenue

Total Cost

Fixed Cost

Quantity

Dollars

Breakeven Quantity

High Fixed Costs with Low Variable Costs

High Breakeven; Profits/Losses Increase Quickly

Variable Cost

Profit

DEGREE OF FINANCIAL LEVERAGE

Measured as the percentage change in earnings per share (EPS) resulting from a one percent change in EBIT

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∆ ∆ ÷ ÷ ÷ EPS EBIT

DFL at X = EPS EBIT

( )− −−

p

EBITDFL at X =

DEBIT I

1 T

DEGREE OF FINANCIAL LEVERAGE Must measure the Degree of Financial Leverage (DFL) at a

given level of EBIT, X

DFL rises as EPS approaches 0

Divide Preferred Share dividends by one minus the tax rate to make them equivalent to interest

DFL rises as more debt is used to replace equity on the Balance Sheet

When $1 of equity is replaced with $1 of debt on the Balance Sheet, the breakeven level of EBIT will rise but EPS share will rise faster, once breakeven has been achieved 15

DEGREE OF COMBINED LEVERAGE

Measured as the percentage change in EPS resulting from a one percent change in sales

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∆ ∆ ÷ ÷ ÷ EPS Sales

DCL at X = EPS Sales

( )− −−

p

Sales - Variable CostsDCL at X =

DEBIT I

1 T

DCL at X = DOL x DFL

DEGREE OF COMBINED LEVERAGE MODEL

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%Change in Sales

%Change in EBIT

%Change in EPS

DOL DFL

DOL & DFL TRADE OFF A firm can “trade off” operating and financial leverage to

control the degree of combined leverage

A firm with a high degree of operating leverage may choose a capital structure with a low degree of financial leverage to avoid a high degree of combined leverage

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FINDING THE PROBABILITY OF EPS

Breakeven EBIT is the amount of EBIT needed to just cover interest charges and preferred share dividends

The Z value tells us the number of standard deviations Breakeven EBIT is from the mean. This can be translated into the probability of achieving an EBIT of less than this amount.

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Breakeven EBIT – Expected EBITStandard deviation of EBIT

Z =

EBIT-EPS ANALYSIS Determine the level of EBIT where EPS would be identical

under either debt or equity financing:

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( ) ( ) ( ) ( )− − − − −=d p e p

d e

EBIT - I 1 T D EBIT I 1 T D

N N

Id = Interest if debt alternative chosenIe = Interest if equity alternative chosenNd = Shares outstanding if debt alternative chosenNe = Shares outstanding if equity alternative chosenT = Firm’s marginal tax rate

GRAPHICAL ANALYSIS OF EBIT - EPS

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EPS

EBIT

Debt Financing

EquityFinancing

IndifferencePoint

Advantage toequity financing

Advantage todebt financing

RISKINESS OF THE CAPITAL STRUCTURE

Compute the expected level of EBIT after expansion

Estimate the variability of operating income

Compute the indifference point between two financing plans

Estimate the probability that EBIT will exceed the indifference point

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RISKINESS OF THE CAPITAL STRUCTURE

Examine the market evidence to see if the capital structure is too risky in relation to the firm’s level of:

Business risk Industry norms for leverage and coverage ratios Recommendation of the firm’s investment bankers

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FACTORS IN CAPITAL STRUCTURE DECISIONS

Tendency to cluster around industry average

Need for funds

Benchmark leverage ratios By lenders and bond rating agencies

Managerial risk aversion

Retain control

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MAJOR POINTS

Leverage is the ability to create a large change in B, given a small change in A. The three types of leverage discussed are: Operating leverage Financial leverage Combined leverage (Operating & Financial)

Operating leverage arises due to the existence of fixed costs

Financial leverage arises due to the existence of debt on the Balance Sheet

High leverage is desirable, in that it magnifies returns but at a cost of additional risk

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