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Leverage
and Capital
Structure
Learning Goals
1. Discuss leverage, capital structure, breakeven
analysis, the operating breakeven point, and the
effect of changing costs on it.
2. Understand operating, financial, and total leverage
and the relationship among them.
3. Describe the basic types of capital, external
assessment of capital structure, the capital structure
of non-U.S. firms, and capital structure theory.
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Learning Goals
4. Explain the optimal capital structure using a graphical
view of the firms cost of capital functions and a zerogrowth valuation model.
5. Discuss the EBIT-EPS approach to capital structure.
6. Review the return and risk of alternative capital
structures, their linkage to market value, and other
important capital structure considerations related to
capital structure.
Copyright 2009 Pearson Prentice
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Leverage
Leverage results from the use of fixed-cost assets or funds to
magnify returns to the firms owners.
Generally, increases in leverage result in increases in risk and
return, whereas decreases in leverage result in decreases in risk
and return.
The amount of leverage in the firms capital structurethe mix
of debt and equitycan significantly affect its value by affecting
risk and return.
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Leverage (cont.)
Table 11.1 General Income Statement Format and Types
of Leverage
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Breakeven Analysis
Breakeven (cost-volume-profit) analysis is used to:
determine the level of operations necessary to cover all
operating costs, and
evaluate the profitability associated with various levels of
sales.
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Breakeven Analysis:
Algebraic Approach
Using the following variables, the operating portion
of a firms income statement may be recast as
follows:
P
FC =
VC =
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Breakeven Analysis:
Algebraic Approach (cont.)
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Breakeven Analysis:
Algebraic Approach (cont.)
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Breakeven Analysis:
Algebraic Approach (cont.)
Example: Cheryls Posters has fixed operating
costs of $2,500, a sales price of $10 per
poster, and variable costs of $5 per poster.
Find the OBP.
Q =
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Breakeven Analysis:
Algebraic Approach (cont.)
We can check to verify that this is the case by
substituting as follows:
EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($10 x 500) - $2,500 - ($5 x 500)
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Breakeven Analysis:
Graphical Approach
Figure 11.1 Breakeven Analysis
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Operating Leverage
Figure 11.2
Operating
Leverage
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Q X (P VC)
Q X (P VC) FC
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Financial Leverage
Financial leverage results from the presence of fixed
financial costs in the firms income stream.
Financial leverage can therefore be defined as the
potential use of fixed financial costs to magnify the
effects of changes in EBIT on the firms EPS.
The two fixed financial costs most commonly found on
the firms income statement are (1) interest on debt and
(2) preferred stock dividends.
Copyright 2009 Pearson Prentice
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EBIT
EBIT I [PD x 1/(1-T)]
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Total Leverage
Total leverage results from the combined effect
of using fixed costs, both operating and
financial, to magnify the effect of changes in
sales on the firms earnings per share.
Total leverage can therefore be viewed as the
total impact of the fixed costs in the firms
operating and financial structure.
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Q x (P VC)
Q x (P VC) FC I [PD x 1/(1-T)]
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Types of Capital
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Capital Structure
of Non-U.S. Firms (cont.)
Furthermore, banks in these countries are permitted to make
large equity investments in non-financial corporationsa
practice forbidden in the U.S.
However, similarities also exist between U.S. firms and their
foreign counterparts.
For example, the same industry patterns of capital structure tend
to be found around the world.
In addition, the capital structures of U.S.-based MNCs tend to be
similar to those of foreign-based MNCs.
Copyright 2009 Pearson Prentice
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EPS-EBIT Approach
to Capital Structure
The EPS-EBIT approach to capital structure involves selecting
the capital structure that maximizes EPS over the expected range
of EBIT.
Using this approach, the emphasis is on maximizing the owners
returns (EPS).
A major shortcoming of this approach is the fact that earnings
are only one of the determinants of shareholder wealth
maximization.
This method does not explicitly consider the impact of risk.
Copyright 2009 Pearson Prentice
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EPS-EBIT Approach
to Capital Structure (cont.)
Example
EBIT-EPS coordinates can be found by assuming specific
EBIT values and calculating the EPS associated with them.
Such calculations for three capital structuresdebt ratios of
0%, 30%, and 60%for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.
Copyright 2009 Pearson Prentice
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EPS-EBIT Approach
to Capital Structure (cont.)
Figure 11.5
EBITEPS
Approach
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Basic Shortcoming
of EPS-EBIT Analysis
Although EPS maximization is generally good for the
firms shareholders, the basic shortcoming of this
method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
Unfortunately, this is not the case.
Copyright 2009 Pearson Prentice
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