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Lecture Note Prof. Roy Sembel, PhD

Leverage and Capital Structure. Lecture Note Prof. Roy Sembel, PhD. PROF. ROY SEMBEL EDUCATION 1982-86 IPB, Bogor. FMIPA. Major: Statistics, Minor: Economics; Ir., Best Graduate, Cum Laude

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Lecture Note Prof. Roy Sembel, PhD

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  1. Leverage and Capital Structure Lecture Note Prof. Roy Sembel, PhD

  2. PROF. ROY SEMBEL EDUCATION 1982-86 IPB, Bogor. FMIPA. Major: Statistics, Minor: Economics; Ir., Best Graduate, Cum Laude 1988-90 Rotterdam School of Management, Erasmus University Rotterdam and The Wharton School, University of Pennsylvania Philadelphia MBA, Finance/Banking, Best Graduate, With Honours 1991-96 J.M.Katz Graduate School of Business, University of Pittsburgh; Major: Corporate Finance; Minor: Econometrics; PhD; Dissertation: “IPO Anomalies, Truncated Excess Supply, and Heterogeneous Information” WORK EXPERIENCE 1984-87 Teaching Assistant, FMIPA, IPB. 1990 Internship; ABN Bank, European Treasury Department, Amsterdam. 1990-91 Corporate Banking; ABN AMRO Bank Amsterdam 1994-96 Teaching Assistant, University of Pittsburgh. 1994-2000 Co-founder Indonesian Physics Olympic Team /TOFI Foundation & Indonesian Computer Olympic Foundation TOKI 1997-98 Economics & Finance Staff, Office of Dr (HC) Radius Prawiro, Jakarta. 2000 ACUCA Lecturer: Japan, South Korea, Taiwan, Hong Kong, The Philippines, Thailand 1987-Now Lecturer, Faculty of Economics, Christian University of Indonesia, Jakarta. 1997-2001 Visiting Lecturer at IPMI, Institut PPM, Magister Management Program University of Indonesia, University of Sam Ratulangi, Universitas Lampung, Magister Akuntansi & Post Graduate (S2 & S3) Program Faculty of Economics University of Indonesia, Pelita Harapan University. Subjects: Investment Analysis and Risk Management, Corporate Finance, International Finance, Derivative Securities, Managerial Economics, Banks & Capital Markets, eBusiness Management.

  3. 1998-2001 McKinsey & Co, Jakarta 2001-2006 Direktur Program Magister Manajemen Keuangan Universitas Bina Nusantara, Co-founder Indonesia Learning Institute (InLIne), Indonesia School of Life (InSchoOL) 2005-2007 Komisaris Independen & Ketua Komite Pemantau Risiko PT Bank Niaga Tbk 2005- Professor in Financial Economics; Charter member Lembaga Komisaris dan Direksi Indonesia 2006-2008 Academic Expert Advisor, Universitas Ciputra Surabaya, 2006- Owner/Komisaris (PT. Mobee Indonesia, PT MARS Indonesia) 2007- Supervisory Committee Asian Bond Fund Indonesia (TCW Bahana/BI), Ketua Komite Sertifikasi FPSB Indonesia 2007-2008 Pejabat Dekan FE Universitas Multimedia Nusantara (UMN) Ketua Umum Partai Barisan Nasional (BARNAS) 2008 Board of Advisor UMN 2008- Ketua Dewan Pembina Partai Barisan Nasional (BARNAS) Chief Research Officer CAPITAL PRICE 2009- Dean of Business School and Director of Graduate Program, UPH MISCELLANEOUS Speaker in many seminars in Indonesia, USA, and Europe. Writer of more than 1000 articles in KONTAN, GATRA, Sinar Harapan, SWA, Bisnis Indonesia, KOMPAS, Investor, Investor Daily, Warta Ekonomi, Manajemen & Usahawan Indonesia, InfoBank, Jurnal Pasar Modal, Media Akuntansi, DIA, Bahana, Jurnal Ekonomi UKI, JAKI, JBR, Scripta Economica UPH, Jurnal, Sinergi MMUII, published books, Internet.

  4. Learning Objectives • Break-even level of sales. • Operating and financial leverage and risk. • Risks and returns of leveraged buy-outs. • Affect of capital structure on value.

  5. Break-even Analysis Steps to Solution • Construct a chart to find the sales break-even point = level of sales necessary to cover operating (not financial) costs. • This requires that you calculate EBIT for different unit sales amounts. • The point at which EBIT = 0 is the break-even level of sales.

  6. Costs $ Variable Costs Fixed Costs Quantity Sold Break-even Analysis Assumptions • Fixed costs remain constant as quantity changes. • Variable costs vary as quantity of output changes: they are constant per unit of output.

  7. Fixed vs. Variable Costs • Fixed costs may include salaries, depreciation, rent. • Variable costs may include commissions, materials, labor.

  8. Break-even Analysis • Calculation of Break-even Quantity EBIT = Sales – Variable Costs - Fixed Costs Find Quantity which results in EBIT = $0

  9. FC p – vc Unit Salesbe = Break-even Analysis • Calculation of Break-even Quantity Where: Unit Salesbe = Break-even quantity FC = Total fixed costs p = Sales price per unit vc = Variable costs per unit

  10. FC p – vc Unit Salesbe = Break-even Analysis • Calculation of Break-even Quantity Example: Fixed Costs = $1,000,000/year Price = $800/unit Variable Costs = $400/unit

  11. FC p – vc Unit Salesbe = Break-even Analysis • Calculation of Break-even Quantity Example: Fixed Costs = $1,000,000/year Price = $800/unit Variable Costs = $400/unit $1,000,000 $800 – $400 = = 2,500 units

  12. Break-even Analysis • Now calculate total revenue. TR = p x Q p = Sales price per unit Q = unit sales

  13. Break-even Analysis • Calculate total revenue for different levels of sales. TR = p x Q Unit sales (Q) x Price (p) = Total Revenue (TR) 0 x $800 = $0 500 x $800 = $ 400,000 1,000 x $800 = $ 800,000 2,000 x $800 = $1,600,000 2,500 x $800 = $2,000,000

  14. Break-even Analysis-Graph Sales & Costs $ • Graphical Analysis of Break-even Point Variable Costs $1,000,000 Fixed Costs Quantity of Units

  15. Break-even Analysis-Graph Sales & Costs $ • Graphical Analysis of Break-even Point Total Costs Variable Costs $1,000,000 Fixed Costs Quantity of Units

  16. Break-even Analysis-Graph Sales & Costs $ • Graphical Analysis of Break-even Point Sales Total Costs Variable Costs $1,000,000 Fixed Costs Quantity of Units

  17. Break-even Analysis-Graph Sales & Costs $ • Graphical Analysis of Break-even Point Sales Total Costs Variable Costs $2,000,000 $1,000,000 Fixed Costs Qbe = 2,500 Quantity of Units

  18. The Concept of Leverage You cannot easily move a large boulder.

  19. The Concept of Leverage However, with the aid of a lever you can move an object many times your size.

  20. The Concept of Leverage The longer the lever, the bigger the rock you can move.

  21. The Concept of Leverage • In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance. • Operating leverage occurs due to fixed costs in the production process. • With high fixed costs, a small change in sales may trigger a large change in operating income (EBIT).

  22. Operating Leverage • Measurement of Operating Leverage • Degree of Operating Leverage (DOL) • DOL > 1 means the firm has operating leverage. % Change in EBIT % Change in Sales DOL=

  23. Operating Leverage Example: fixed costs = $1 and no variable costs EBIT for Sales of $3 = $3 - $1 = $2 EBIT for Sales of $4 = $4 - $1 = $3 % Change in EBIT % Change in Sales DOL= ($3 - $2)/$2 .50 ($4 - $3)/$3 .33 DOL = = = 1.5

  24. Operating Leverage • Measurement of DOL • Calculation using per unit information: Sales - Total VC Sales-Total VC-FC DOL=

  25. Operating Leverage • Measurement of DOL • Calculation using per unit information: Sales - Total VC Sales-Total VC-FC DOL= Example: Q = 3,750 units P = $800 per unit VC = $400 per unit FC = $1,000,000 per year.

  26. Operating Leverage • Measurement of DOL • Calculation using per unit information: Sales - Total VC Sales-Total VC-FC DOL= 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000 DOL3,750 units =

  27. Operating Leverage • Measurement of DOL • Calculation using per unit information: Sales - Total VC Sales-Total VC-FC DOL= 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000 DOL3,750 units = = 3 Interpretation: If sales change 1%, then EBIT will change 3% (same direction).

  28. Operating Leverage • Degree of Operating Leverage falls as sales rise Quantity DOL 2,500 (Qbe) Undefined 3,250 4.33 3,750 3 5,000 2

  29. Operating Leverage • Degree of Operating Leverage falls as sales rise Quantity DOL 2,500 (Qbe) Undefined 3,250 4.33 3,750 3 5,000 2 • The higher the sales level above break-even, the less EBIT changes as sales change • If FC = $0, DOL = 1

  30. Financial Leverage • Degree of Financial Leverage

  31. Financial Leverage • Degree of Financial Leverage • Finance a portion of the firm’s assets with securities that have fixed financial costs • Debt • Preferred Stock

  32. Financial Leverage • Degree of Financial Leverage • Finance a portion of the firm’s assets with securities that have fixed financial costs • Debt • Preferred Stock • Financial Leverage measures changes in earnings per share as EBIT changes.

  33. Financial Leverage • Degree of Financial Leverage • Finance a portion of the firm’s assets with securities that have fixed financial costs • Debt • Preferred Stock • Financial Leverage measures changes in earnings per share as EBIT changes. % Change in NI % Change in EBIT DFLEBIT = Unique Level of EBIT

  34. Financial Leverage • Measurement of DFL (Alternative formula) • If DFL > 1, the firm has financial leverage. An increase in EBIT wil result in a larger increase in NI. EBIT EBIT – I DFLEBIT =

  35. Financial Leverage Example: EBIT = $500,000 Interest Charges = $200,000

  36. Financial Leverage Example: EBIT = $500,000 Interest Charges = $200,000 500,000 500,000 – 200,000 DFLEBIT=500,000 = = 1.67 times

  37. Financial Leverage Example: EBIT = $500,000 Interest Charges = $200,000 500,000 500,000 – 200,000 DFLEBIT=500,000 = = 1.67 times Interpretation: When EBIT changes 1% (from an existing level of $500,000) Earnings Per Share will change 1.67%

  38. Combined Leverage • Degree of Combined Leverage • Measures changes in Net Income given changes in Sales

  39. Combined Leverage • Degree of Combined Leverage • Measures changes in Net Income given changes in Sales • Combines both Operating and Financial Leverage

  40. Combined Leverage • Degree of Combined Leverage • Measures changes in Net Income given changes in Sales • Combines both Operating and Financial Leverage • Computed for a specific level of sales

  41. Combined Leverage • Degree of Combined Leverage • Measures changes in Net Income given changes in Sales • Combines both Operating and Financial Leverage • Computed for a specific level of sales % Change in EPS % Change in Sales DCLS = Unique Level of Sales

  42. Combined Leverage DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0

  43. Combined Leverage DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0x 1.67 = 5.0 times

  44. Combined Leverage DCLS = DOLS x DFLEBIT Example: DFLEBIT = 1.67 DOLS = 3.0 DCL3,750 = 3.0x 1.67 = 5.0 times Interpretation: When sales change 1%, Net Income will change 5.0%

  45. Effect of Leverage • Leverage can help the firm or hurt it. • If EBIT increases, leverage will cause net income to increase even more. • If EBIT decreases, leverage will cause a larger decline in net income.

  46. Capital Structure Theory • Capital Structure is the mixture of sources of funds a firm uses. • Debt • Preferred Stock • Common Stock

  47. Capital Structure Theory • A benefit of debt financing is that interest is tax deductible whereas payments to equity providers are not. • Firms must trade off this benefit against the increased financial risk associated with higher debt levels.

  48. Capital Structure Theory-Modigliani and Miller (MM) • MM wrote an important paper in 1958 in which they proved that with tax deductibility of interest payments, the optimal capital structure is 100% debt. • Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations.

  49. Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50

  50. EPS and ROE Under Current Capital Structure Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares

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