Ch. 10: Determining the Financing Mix How do we want to finance our firm’s assets? MF

Ch. 10: Determining the

Financing Mix

DebtPreferredEquity

How do we want How do we want to finance our to finance our firm’s assets?firm’s assets?

MF

Determining the Financing Mix

Operating LeverageOperating Leverage Financial LeverageFinancial Leverage Capital StructureCapital Structure

What is Leverage?

What is Leverage?

What is Leverage?

2 concepts that enhance our understanding of risk...

1) 1) Operating LeverageOperating Leverage - affects a - affects a firm’s firm’s business riskbusiness risk..

2) 2) Financial LeverageFinancial Leverage - affects a - affects a firm’s firm’s financial riskfinancial risk..

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s firm’s operating income (EBIT).operating income (EBIT).

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

EBIT

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT EPS

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Business Risk

The variability or uncertainty of a The variability or uncertainty of a firm’s operating income (EBIT).firm’s operating income (EBIT).

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Business Risk

Affected by:Affected by: Sales volume variabilitySales volume variability CompetitionCompetition Cost variabilityCost variability Product diversificationProduct diversification Product demandProduct demand Operating LeverageOperating Leverage

Operating Leverage

The use of The use of fixed operating costsfixed operating costs as as opposed to opposed to variable operating variable operating costs.costs.

A firm with relatively high fixed A firm with relatively high fixed operating costs will experience operating costs will experience more variable operating incomemore variable operating income if if sales change.sales change.

EBIT

OperatingOperatingLeverageLeverage

Financial Risk

The The variability or uncertainty of variability or uncertainty of a firm’s earnings per sharea firm’s earnings per share (EPS) (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..

Financial Risk

The variability or uncertainty of The variability or uncertainty of a firm’s a firm’s earnings per shareearnings per share (EPS) (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Financial Risk

The variability or uncertainty of The variability or uncertainty of a firm’s earnings per share (EPS) a firm’s earnings per share (EPS) and the increased probability of and the increased probability of insolvency that arises when a insolvency that arises when a firm uses firm uses financial leveragefinancial leverage..

FIRMFIRMEBIT EPSStock-Stock-holdersholders

Financial Leverage

The use of The use of fixed-costfixed-cost sources of sources of financingfinancing (debt, preferred stock) (debt, preferred stock) rather than rather than variable-costvariable-cost sources sources (common stock).(common stock).

EPS

FinancialLeverage

Breakeven Analysis

Illustrates the effects of Illustrates the effects of operating operating leverageleverage..

Useful for forecasting the Useful for forecasting the profitability of a firm, division or profitability of a firm, division or product line.product line.

Useful for analyzing the impact of Useful for analyzing the impact of changes in fixed costs, variable changes in fixed costs, variable costs, and sales price.costs, and sales price.

QuantityQuantity

$$Breakeven AnalysisBreakeven Analysis

QuantityQuantity

$$

Total RevenueTotal Revenue

Costs

Suppose the firm has both Suppose the firm has both fixed fixed operating costsoperating costs (administrative (administrative salaries, insurance, rent, property salaries, insurance, rent, property tax) and tax) and variable operating costsvariable operating costs (materials, labor, energy, packaging, (materials, labor, energy, packaging, sales commissions).sales commissions).

QuantityQuantity

$$

QuantityQuantity

$$

Total RevenueTotal Revenue

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost

FCFC

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost

FCFC

Q1

+

-

}} EBITEBIT

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost

FCFC

Break-Break-evenevenpointpoint

Q1

+

-

}} EBITEBIT

Operating Leverage

What happens if the firm increases What happens if the firm increases its fixed operating costs and reduces its fixed operating costs and reduces (or eliminates) its variable costs?(or eliminates) its variable costs?

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost

FCFC

Break-Break-evenevenpointpoint

Q1

+

-

}} EBITEBIT

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost= Fixed= FixedFCFC

Break-Break-evenevenpointpoint

}}

QQ11

++

--

EBITEBIT

With high With high operating leverageoperating leverage, , an increase in an increase in salessales

produces a relatively larger produces a relatively larger increase in increase in operating operating

incomeincome..

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost= Fixed= FixedFCFC

Break-Break-evenevenpointpoint

}}

QQ11

++

--

EBITEBIT

QuantityQuantity

{{

$$

Total RevenueTotal Revenue

Total CostTotal Cost= Fixed= FixedFCFC

Break-Break-evenevenpointpoint

}}

QQ11

++

--

EBITEBIT

Trade-off: Trade-off: the firm hasthe firm has

a higher breakeven a higher breakeven point. If sales are not point. If sales are not high enough, the firm high enough, the firm will not meet its fixedwill not meet its fixed

expenses!expenses!

Breakeven Calculations

Breakeven Calculations

Breakeven point (units of output)Breakeven point (units of output)

QQBB = = FFP - VP - V

Breakeven Calculations

Breakeven point (units of output)Breakeven point (units of output)

QQB = B = breakeven level of Q.breakeven level of Q. F = total anticipated fixed costs.F = total anticipated fixed costs. P = sales price per unit.P = sales price per unit. V = variable cost per unit.V = variable cost per unit.

QQBB = = FFP - VP - V

Breakeven Calculations

S* = S* = FF VCVC SS

1 -1 -

Breakeven point (sales dollars)Breakeven point (sales dollars)

Breakeven point (sales dollars)Breakeven point (sales dollars)

S* = breakeven level of sales.S* = breakeven level of sales. F = total anticipated fixed costs.F = total anticipated fixed costs. S = total sales.S = total sales. VC = total variable costs.VC = total variable costs.

Breakeven Calculations

S* = S* = FF VCVC SS

1 -1 -

Analytical Income Statement

salessales

- variable costs- variable costs

-- fixed costs fixed costs

operating incomeoperating income

-- interest interest

EBTEBT

-- taxes taxes

net incomenet income

salessales

- variable costs- variable costs

-- fixed costs fixed costs

operating incomeoperating income

-- interest interest

EBTEBT

-- taxes taxes

net incomenet income

}} contribution margin contribution margin}} contribution margin contribution margin

Analytical Income Statement

salessales

- variable costs- variable costs

-- fixed costs fixed costs

operating incomeoperating income

-- interest interest

EBTEBT

-- taxes taxes

net incomenet income

}} contribution margin contribution margin}} contribution margin contribution margin

Analytical Income Statement

EBT (1 - t) = Net Income, EBT (1 - t) = Net Income,

so,so,

Net Income / (1 - t) = EBTNet Income / (1 - t) = EBT

EBT (1 - t) = Net Income, EBT (1 - t) = Net Income,

so,so,

Net Income / (1 - t) = EBTNet Income / (1 - t) = EBT

Degree of Operating Leverage (DOL)

Operating leverageOperating leverage:: by using fixed by using fixed operating costs, a small change in operating costs, a small change in sales revenuesales revenue is magnified into a is magnified into a larger change in larger change in operating incomeoperating income..

This “multiplier effect” is called This “multiplier effect” is called the the degree of operating leveragedegree of operating leverage..

DOLs = DOLs = % change in EBIT% change in EBIT% change in sales% change in sales

Degree of Operating Leveragefrom Sales Level (S)

DOLs = DOLs = % change in EBIT% change in EBIT% change in sales% change in sales

change in EBITchange in EBIT EBITEBITchange in saleschange in sales salessales

=

Degree of Operating Leveragefrom Sales Level (S)

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Operating Leveragefrom Sales Level (S)

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Operating Leveragefrom Sales Level (S)

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Operating Leveragefrom Sales Level (S)

Q(P - V) Q(P - V) Q(P - V) - FQ(P - V) - F

=

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

What does this tell us?

If If DOL = DOL = 22,, then a then a 1%1% increase in increase in salessales will result in a will result in a 2%2% increase in increase in operating incomeoperating income (EBIT). (EBIT).

What does this tell us?

If If DOL = 2,DOL = 2, then a then a 1%1% increase in increase in sales will result in a sales will result in a 2%2% increase in increase in operating income (EBIT).operating income (EBIT).

Stock-holdersEBIT EPSSales

What does this tell us?

If If DOL = 2,DOL = 2, then a then a 1%1% increase in increase in sales will result in a sales will result in a 2%2% increase in increase in operating income (EBIT).operating income (EBIT).

Stock-holdersEBIT EPSSales

Degree of Financial Leverage (DFL)

Financial leverageFinancial leverage: by using fixed : by using fixed cost financing, a small change in cost financing, a small change in operating incomeoperating income is magnified into a is magnified into a larger change in larger change in earnings per shareearnings per share..

This “multiplier effect” is called the This “multiplier effect” is called the degree of financial leveragedegree of financial leverage..

DFL = DFL = % change in EPS% change in EPS% change in EBIT% change in EBIT

Degree of Financial Leverage

DFL = DFL = % change in EPS% change in EPS% change in EBIT% change in EBIT

change in EPSchange in EPS EPSEPSchange in EBITchange in EBIT EBITEBIT

Degree of Financial Leverage

=

Degree of Financial Leverage

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Financial Leverage

DFL = DFL = EBIT EBIT EBIT - IEBIT - I

If we have the data, we can use this formula:If we have the data, we can use this formula:

What does this tell us?

If If DFL = DFL = 33, then a , then a 1%1% increase in increase in operatingoperating incomeincome will result in a will result in a 3%3% increase in increase in earningsearnings perper shareshare..

What does this tell us?

If If DFL = 3DFL = 3, then a , then a 1%1% increase in increase in operating income will result in a operating income will result in a 3%3% increase in earnings per share.increase in earnings per share.

Stock-holdersEBIT EPSSales

What does this tell us?

If If DFL = 3DFL = 3, then a , then a 1%1% increase in increase in operating income will result in a operating income will result in a 3%3% increase in earnings per share.increase in earnings per share.

Stock-holdersEBIT EPSSales

Degree of Combined Leverage (DCL)

Combined leverageCombined leverage:: by using by using operating operating leverageleverage and and financial leveragefinancial leverage, a small , a small change in change in salessales is magnified into a larger is magnified into a larger change in change in earnings per shareearnings per share..

This “multiplier effect” is called the This “multiplier effect” is called the degree of combined leveragedegree of combined leverage..

Degree of Combined Leverage

DCL = DOL x DFL DCL = DOL x DFL

Degree of Combined Leverage

DCL = DOL x DFL DCL = DOL x DFL

% change in EPS% change in EPS% change in Sales% change in Sales

Degree of Combined Leverage

==

DCL = DOL x DFL DCL = DOL x DFL

% change in EPS% change in EPS% change in Sales% change in Sales

Degree of Combined Leverage

==

change in EPSchange in EPS EPSEPSchange in Saleschange in Sales SalesSales

=

Degree of Combined Leverage Degree of Combined Leverage

If we have the data, we can use this formula:If we have the data, we can use this formula:

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

If we have the data, we can use this formula:If we have the data, we can use this formula:

Degree of Combined Leverage

Degree of Combined Leverage

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

If we have the data, we can use this formula:If we have the data, we can use this formula:

Q(P - V) Q(P - V) Q(P - V) - F - IQ(P - V) - F - I

=

What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

Stock-holdersEBIT EPSSales

What does this tell us?

If If DCL = 4DCL = 4, then a , then a 1%1% increase in increase in sales will result in a sales will result in a 4%4% increase in increase in earnings per share.earnings per share.

Stock-holdersEBIT EPSSales

In-class Project:In-class Project: Based on the following information on Based on the following information on

Levered Company, answer these Levered Company, answer these questions:questions:

1) If 1) If salessales increase by 10%, what should increase by 10%, what should happen to happen to operating incomeoperating income??

2) If 2) If operating incomeoperating income increases by 10%, increases by 10%, what should happen to what should happen to EPSEPS??

3) If 3) If salessales increase by 10%, what should be increase by 10%, what should be the effect on the effect on EPSEPS??

Levered Company

Sales (100,000 units)Sales (100,000 units) $1,400,000$1,400,000

Variable CostsVariable Costs $800,000$800,000

Fixed CostsFixed Costs $250,000$250,000

Interest paidInterest paid $125,000$125,000

Tax rateTax rate 34%34%

Common shares outstandingCommon shares outstanding 100,000100,000

SalesSales

EBITEBITEPSEPS

DOL

DFL

DCL

Leverage

Levered Company

SalesSales

EBITEBITEPSEPS

DOL =DOL =

DFLDFL

DCLDCL

Degree of Operating Leverage from Sales Level (S)

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

Degree of Operating Leverage from Sales Level (S)

1,400,000 - 800,0001,400,000 - 800,000 350,000350,000

=

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

Degree of Operating Leverage from Sales Level (S)

1,400,000 - 800,0001,400,000 - 800,000 350,000350,000

= 1.714= 1.714

=

DOLs = DOLs = Sales - Variable CostsSales - Variable Costs EBITEBIT

Levered Company

SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL =

DCLDCL

Degree of Financial Leverage

DFL = DFL = EBIT EBIT EBIT - IEBIT - I

Degree of Financial Leverage

DFL = DFL = EBIT EBIT EBIT - IEBIT - I

= = 350,000 350,000 225,000225,000

Degree of Financial Leverage

DFL = DFL = EBIT EBIT EBIT - IEBIT - I

= = 350,000 350,000 225,000225,000

= 1.556= 1.556

Levered Company

SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL = 1.5561.556

DCLDCL

Degree of Combined Leverage

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

Degree of Combined Leverage

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

1,400,000 - 800,000 1,400,000 - 800,000 225,000225,000

=

Degree of Combined Leverage

DCL = DCL = Sales - Variable Costs Sales - Variable Costs EBIT - IEBIT - I

1,400,000 - 800,000 1,400,000 - 800,000 225,000225,000

= 2.667= 2.667

=

Levered Company

SalesSales

EBITEBITEPSEPS

DOL = 1.714DOL = 1.714

DFL = DFL = 1.5561.556

DCLDCL= 2.667= 2.667

Sales (110,000 units)Sales (110,000 units) 1,540,0001,540,000

Variable CostsVariable Costs (880,000) (880,000)

Fixed CostsFixed Costs (250,000)(250,000)

EBITEBIT 410,000410,000 ( +17.14%)( +17.14%)

InterestInterest (125,000)(125,000)

EBTEBT 285,000 285,000

Taxes (34%)Taxes (34%) (96,900)(96,900)

Net IncomeNet Income 188,100 188,100

EPSEPS $1.881$1.881 ( +26.67%)( +26.67%)

Levered Company10% increase in sales