Copyright © 2003 Pearson Education, Inc. Slide 11-1 Ch 11 Learning Goals 1. Operating, financial, and total leverage (causes & measures). 2. Business risk, financial risk & total risk. 3. Optimal capital structure. 4. Identifying the optimal capital structure.
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Copyright © 2003 Pearson Education, Inc. Slide 11-1
Ch 11 Learning Goals
1. Operating, financial, and total leverage
(causes & measures).
2. Business risk, financial risk & total risk.
3. Optimal capital structure.
4. Identifying the optimal capital structure.
Copyright © 2003 Pearson Education, Inc. Slide 11-2
Leverage
• A change in sales revenue often causes a
_________________ percentage change in
earnings.
– Cause: __________________ costs
– Name: “leverage”
Copyright © 2003 Pearson Education, Inc. Slide 11-3
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 11-4
Leverage
• Generally, higher leverage means:
– Increased ____________.
– Increased potential __________________.
Copyright © 2003 Pearson Education, Inc. Slide 11-5
Operating Leverage
Copyright © 2003 Pearson Education, Inc. Slide 11-6
Degree of Operating Leverage
• The degree of operating leverage (DOL)
measures the sensitivity of ________________
to changes in __________________.
• DOL can be calculated by:
– interval estimate
– point estimate
Operating Leverage
Copyright © 2003 Pearson Education, Inc. Slide 11-7
Financial Leverage
Copyright © 2003 Pearson Education, Inc. Slide 11-8
Degree of Financial Leverage
• The degree of financial leverage (DFL)
measures the sensitivity of ____________ (or
net profit after tax) to changes in ___________.
• Like the DOL, DFL can be calculated by:
– interval estimate
– point estimate
Financial Leverage
Copyright © 2003 Pearson Education, Inc. Slide 11-9
• 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 11-10
DTL = DOL x DFL
Total Leverage
Degree of Total Leverage
The relationship between the DTL, DOL
& DFL:
Copyright © 2003 Pearson Education, Inc. Slide 11-11
Capital Structure
• The firm’s capital structure is the mix of debt
and equity it uses to finance fixed assets.
• There is an optimal, or __________________
capital structure for each firm.
Copyright © 2003 Pearson Education, Inc. Slide 11-12
Capital Structure
• The optimal capital structure balances the ____________________ of debt with the ________________ of debt financing.
Copyright © 2003 Pearson Education, Inc. Slide 11-13
Capital Structure
• The optimal capital structure for a particular firm depends on:
– its business _____________
– the ___________________________ of its owners and managers
Copyright © 2003 Pearson Education, Inc. Slide 11-14
Determinants of Business Risk
High business risk is the result of
high fixed operating costs (high ______)
unstable demand for firm’s products
volatile costs (raw materials, for example)
Copyright © 2003 Pearson Education, Inc. Slide 11-15
Financial RiskFinancial Risk
• Financial risk is the risk that the firm cannot
meet its financial obligations.
Copyright © 2003 Pearson Education, Inc. Slide 11-16
Financial Risk
• Indicators of financial risk– High ____________– High debt ratio– Low coverage ratios (times interest earned,
etc.)
Copyright © 2003 Pearson Education, Inc. Slide 11-17
Capital Structure
• The total risk a firm faces (and the probability of
bankruptcy) are the result of both business risk
and financial risk.
Probability of Bankruptcy
Copyright © 2003 Pearson Education, Inc. Slide 11-18
Capital Structure
• Firms with high business risk should use _____________ debt financing. As a result, the optimal capital structure is not the same for all industries or firms.
Copyright © 2003 Pearson Education, Inc. Slide 11-19
Capital Structure
• The optimal capital structure results in:
– Minimum ____________
– Maximum _____________
Copyright © 2003 Pearson Education, Inc. Slide 11-20
Graphically
WACC
k
Debt Ratio0 Target
Capital Structure
The Optimal Capital Structure
Copyright © 2003 Pearson Education, Inc. Slide 11-21
GraphicallyStock Price ($)
Debt Ratio0 Target
Capital Structure
P($)
The Optimal Capital Structure
Copyright © 2003 Pearson Education, Inc. Slide 11-22
Analyzing Capital Structure
To compare alternative optimal capital structures:
(1)Estimate eps for each
(2)Estimate resulting stock price for each
(3)Pick the one with highest stock price
Or
(1)Estimate WACC for each
(2)Pick the one with lowest WACC
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