Copyright 2003 South-Western/Thomson Learning

Chapter
14
Capital Structure Management
in Practice
Introduction
This chapter focuses on the impact of
leverage on corporate profits. We will
cover:

Operating and financial leverage (pp.
472-475)
Breakeven analysis (Appendix 14A)
EBIT-EPS analysis (pp. 482-493)




Operating and Financial Leverage
Based on fixed operating and/or fixed
capital costs:
Fixed operating costsassets added to
grow the firm
Depreciation of PP&E
Rent and utility costs
Property taxes
Salaried costs
Fixed capital costfunds the assets
Interest charges
Preferred dividends

Operating and Financial Leverage
Operating Leverage
Results from fixed operating costs such that a
change in sales revenue is magnified into a
relatively large change in EBIT
Financial Leverage
Results from fixed capital costs such that a
change in EBIT is magnified into a relatively
large change in EPS

Benefits of leverage occur only within
specific range of volumes until the firm
needs to commit additional fixed operating
or capital costs




See Table 14.2, p.475
Breakeven Analysis (Appendix 14A,
p. 505)
Also called cost-volume-profit
analysis
Describes relationship among firms
sales, fixed cost (FC), variable costs
(VC), and EBIT/EPS at various unit
output levels (Q)
Main objective: at what sales level (Q)
does the firm break even?
Graphical Breakeven Analysis
Graph both revenue and cost in $ on y
axis versus output (Q) in units on x axis:
Graph Total Revenue (TR = Q x
Price/unit) beginning at origin
Graph Total Cost (FC + VC) beginning
with FC on y axis
Breakeven is where TR and TC cross
TR = TC
See Fig. 14A.1, p. 506
Algebraic Breakeven Analysis
Total Revenue (TR) = Total Cost (TC)
TR = VC + FC
TR = VC/unit x units + FC
Sales/unit x units = VC/unit x units + FC
Sales/unit x units VC/unit x units = FC
(Sales/unit VC/unit) units = FC
Note: Sales/unit VC/unit = Price-VC/unit =
contribution margin ( econ. profit)/unit
Therefore:
B.E units (Q) = FC/contrib. margin/unit




Example: Allegan Mfg. Co
FC = $1 mils, Price (P) = $250, VC/unit =
$150
Qb = $1 mils/$250 $150 = 10,000 units
Incr. P by $25
Qb = $ 1 mils/$275 - $150 = 8000 units
Spend CapEx of $1 mils ($100,000/yr in
depreciation) to reduce VC/unit by $25
Qb = $1.1 mils/$250 - $125 = 8800 units

Ex: pp. 507-509 (same example in detail)



Other Applications
1. Analyzing effects of other variables, e.g.,
price (prior slide)
2. Breakeven in terms of $ sales (p. 507)
Sb = FC/ 1- (VC/P)
3. Breakeven in terms of EBT or EPS (add Int.
to FC = fixed charges)
4. Target Volume (p. 507)
Qt = (FC + Target Profit)/Contribution
Margin/unit
5. Cash breakeven (p. 512-513)
Qc = (FC Depr.)/Contri. Margin/unit
Note: Useful for homework #7

Use EBIT-EPS analysis for determining
debt versus equity financing for individual
projects
But, should maintain target capital structure
Steps
Develop economic/profit scenarios
Begin with Earnings before Interest and Taxes
(EBIT) and calculate Earnings Per Share (EPS)
for both alternatives
Best alternative has highest earnings per share
Other considerations: flexibility, dilution of
ownership/earnings, use of cash

See Ex, p. 482

EBIT-EPS Analysis
EBIT-EPS Analysis Breakeven
More accurate method of determining when to
offer equity or debtcalculate indifference
point
Determine the level of EBIT where EPS would
be identical under either debt or equity
financing: EPS (debt fin.)=EPS (equity fin.), or



Debt financing
Equity financing
=
N
e
(EBIT I
e
) (1 T) D
p
N
d
(EBIT I
d
) (1 - T) D
p
See Ex. p. 484
Graphical Analysis of EBIT - EPS
EPS
EBIT
Debt Financing
Equity Financing
Indifference Point
Advantage to debt
financing
Advantage to
equity financing
Analyze the Riskiness of the
Capital Structure For Expansion
1. Compute the expected level of EBIT after expansion.
2. Estimate the variability of operating income (Stnd.
Dev.).
3. Compute the indifference point between two financing
plans.
4. Estimate the probability that EBIT will exceed the
indifference point (calc. z and use Table V).
5. Examine the market evidence to see if the capital
structure is too risky in relation to the firms level of
Business risk
Industry norms for leverage and coverage ratios
Recommendation of the firms investment bankers
Ex:, pp. 485-486
Warning!
Remember, financial leverage is a
double-edged sword; it enhances
expected returns but also increases risk

Even if EPS is higher with debt financing,
high leverage could result in lower PE,
and lower stock price (bottom p. 486)

Lesson: the market will say whether
borrowing is too risky


Cash Insolvency Analysis (p. 487)
Helps managers choose their capital structure
during a recession when liquidity is important
CB
R
= CB
0
+ FCF
R

CB
0
= cash at beginning of period,
FCF
R
= free cash flows during recession, and
CB
R
= cash balance during recession (you want
it to be positive)


Firms needs cash (or access to cash) to survive
a recession

Therefore, make CB
0
large enough or have
guaranteed access to bank credit and other
sources of cash, e.g., auto company
Factors Considered 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
Summary
Operating Leverage--results from fixed operating
costs such that a change in sales revenue is magnified
into a relatively large change in EBIT

Financial Leverage--results from fixed capital costs
such that a change in EBIT is magnified into a relatively
large change in EPS

Break-even Analysis--relationship among firms
sales, fixed cost (FC), variable costs (VC), and
EBIT/EPS at various unit output levels (Q)

EBIT-EPS Analysis--determines whether debt or
equity financing is preferred based on maximizing EPS

Cash Insolvency Analysis--Helps determine capital
structure during a recession when liquidity is important

ApplicationExamples, pp. 507-513
Homework Problems
In this order: Ch 14: # 20, 14A: # 1
Assignment # 7: For Ford Automotive calculate
the following:
1. Break-even units for EBIT
2. Break-even units for EBT
3. Graph TR and TC vs units showing #2
4. Units required to earn targeted EBT of $5 bils
5. Your realistic plan for #4 involving volume,
cost and/or price changes (see Allegan Mfg.)
Next Class: Chapters 16 & 19