Ch 14 Capital Structure&Leverage1

8/4/2019 Ch 14 Capital Structure&Leverage1

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Chapter 14:Capital Structure & Leverage

()

(Break Even Point BEP)


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=

ASSET =

Liability

Equity


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()

()

()

(rs) (beta[] )


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(Opportunity Cost)

() - EPS, ROE

dilution


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2 :

(WACC)

discount rate

(Financial

Risk)

Beta (CAPM)


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=+

=

1t

tt

)WACC1(FCFV

WACC = wd (1-T) rd + we rs

V = (value of firm) FCF = (free cash flow)

WACC = (weighted average cost of capital)

re rd(cost of stock) (Cost of debt)

we wd


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Business Risk versus Financial Risk

Business risk:.

Operation Leverage

Financial risk:

Financial Risk


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(pre-taxoperating income (EBIT)).

(business risk)

Probability

EBITE(EBIT)0

Low risk

High risk


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Business Risk

Demand (unit sales).

Sales prices.

Input cost variability.

Cost pushing

Ability to develop new product Forex risk exposure

Fixed cost


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Operation Leverage

Operating leverage

Operating leverage

Operatingleverage


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operating leverage

(More...)

Sales

$ Rev.

TC

F

QBE Sales

$ Rev.

TC

F

QBE

EBIT

}


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Probability

EBITL

Low operating leverage

High operating leverage

EBITH

Operation Leverage


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Financial Risk

Financial risk:

(Default risk)


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U L

10,000 12%

5,000 5,000 $20,000 $20,000

5,000 5,000

0 10,000 (1$) $15,000 (1$) $5,000 40% 40%

2


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Financial Leverage

$3,000 $3,000 0 1,200

$3,000 $1,800 (40%) 1 ,200 720 $1,800 $1,080

ROE 9.0% 10.8%

U L


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L

.:

U: = $1,800.

L: = $1,080 + $1,200 =$2,280.

: U: $1,200; L: $720.


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Financial Leverage

Prob. 0.25 0.50 0.25 5,000 7,000 9,000 $2,000 $3,000 $4,000 0 0 0 $2,000 $3,000 $4,000

(40%) 800 1,200 1,600 $1,200 $1,800 $2,400

Economy

Bad Avg. Good

U


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Financial Leverage

Prob.* 0.25 0.50 0.25 5,000 7,000 9,000

$2,000 $3,000 $4,000 1,200 1,200 1,200 $ 800 $1,800 $2,800 (40%) 320 720 1,120

$ 480 $1,080 $1,680

*Same as for Firm U.

Economy

Bad Avg. Good

L


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2 (Asset Management

Ratio)

(Profitability)

(Debt ManagementRatio)

Basic Earning Power (BEP)

Return on Equity (ROE)

Times Interest Earned (TIE)


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Firm U Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%

TIE n.a. n.a. n.a.

Firm L Bad Avg. GoodBEP 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%

TIE 1.7x 2.5x 3.3x


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L U

Basic earning power (EBIT/TA) ROIC

(NOPAT/Capital = EBIT(1-T)/TA) Financial levergae

L ROE

L ROE Financial Leverage


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Optimal Capital Structure:

=


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(Debt

Ratios)

Debt/Equity

Debt/Asset

Interest Coverage (Times Interest Earned: TIE)

EBITDA/Interest

Current Ratio

Etc.

Policy

Rating

( )


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(Break Even)

Operating breakeven = QBE

QBE = F / (P V)

Q , F , V,TC P .

Example: F=$200, P=$15, and V=$10:

QBE = $200 / ($15 $10) = 40.


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(Break Even)


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120 70,000 55

1. 60, 70, 80, 90

2. 80,000 90,000

Ch 14 Capital Structure&Leverage1

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