Principles of Managerial Finance

1. Principles of Managerial Finance Chapter 12 Leverage & Capital Structure

2. Learning Objectives • Discuss the role of breakeven analysis, how to determine the operating breakeven point, and the effect of changing costs on the breakeven point. • Understand operating, financial, and total leverage and the relationship among them. • Describe the basic types of capital, external assessment of capital structure, capital structure of non-U.S. firms, and capital structure theory.

3. Learning Objectives • Explain the optimal capital structure using a graphic view of the firm’s cost of capital functions and a modified form of zero-growth valuation model. • Discuss the graphic presentation, risk considerations, and basic shortcomings of EBIT-EPS approach to capital structure. • Review the return and risk of alternative capital structures and their linkage to market value, and other important capital structure considerations.

4. Leverage Sales revenue和EBIT之間的關係 Sales revenue和EPS之間的關係 EBIT和EPS之間的關係

5. 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. • The firm’s operating breakeven point (OBP) is the level of sales necessary to cover all operating expenses. • At the OBP, operating profit (EBIT) is equal to zero.

6. Breakeven Analysis • To calculate the OBP, cost of goods sold and operating expenses must be categorized as fixed or variable. • Variable costs vary directly with the level of sales and are a function of volume, not time. • Examples would include direct labor and shipping. • Fixed costs are a function of time and do not vary with sales volume. • Examples would include rent and fixed overhead.

7. Breakeven Analysis Algebraic Approach • Using the following variables, the operating portion of a firm’s income statement may be recast as follows: P = sales price per unit Q = sales quantity in units FC = fixed operating costs per period VC = variable operating costs per unit EBIT = (P x Q) - FC - (VC x Q) • Letting EBIT = 0 and solving for Q, we get:

8. Breakeven Analysis Algebraic Approach • Using the following variables, the operating portion of a firm’s income statement may be recast as follows: P = sales price per unit Q = sales quantity in units FC = fixed operating costs per period VC = variable operating costs per unit Q = FC P - VC

9. Breakeven Analysis Algebraic Approach

10. Breakeven Analysis Algebraic Approach • Example: Omnibus Posters has fixed operating costs of $2,500, a sales price of $10/poster, and variable costs of $5/poster. Find the OBP. Q = $2,500 = 500 posters $10 - $5 • This implies that if Omnibus sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).

11. Breakeven Analysis Algebraic Approach • 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) EBIT = $5,000 - $2,500 - $2,500 = $0

12. Breakeven Analysis Graphic Approach

13. Breakeven Analysis EBIT>0 Operating breakeven point EBIT<0

14. Operating & Financial Leverage

15. Operating & Financial Leverage

16. Operating & Financial Leverage Degree of Operating Leverage • operating leverage=the potential use of fixed operating costs to magnify the effects of changes in sales on the firm’s EBIT • The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales. • A company’s DOL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DOL. • Only companies that use fixed costs in the production process will experience operating leverage.

17. Operating & Financial Leverage Degree of Operating Leverage

18. Operating & Financial Leverage Degree of Operating Leverage DOL愈大表示operating risk愈大，DOL>1表示有operating leverage Interval Estimate of DOL DOL = % Change in EBIT = 35% = 3.50 % Change in Sales 10% Because of the presence of fixed costs in the firm’s production process, a 10% increase in Sales will result in a 35% increase in EBIT. Note that in the absence of operating leverage (if Fixed Costs were zero), the DOL would equal 1 and a 10% increase in Sales would result in a 10% increase in EBIT.

19. Operating & Financial Leverage Degree of Operating Leverage Point Estimate of DOL 當FC相對於VC愈大時，DOL也愈大，例如：公司決定增加sales的salary，減少sales commission DOL = Sales - VC = 700 - 420 = 3.50 Sales - VC - FC 700 - 420 - 200 Care must be taken when using the point estimate because the DOL will be different at different levels of sales. For Example, if sales increase to 770, DOL will decline as follows: DOL = Sales - VC = 770 - 462 = 2.08 Sales - VC - FC 770 - 462 - 200

20. Operating & Financial Leverage Degree of Financial Leverage • Financial leverage=potential use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS • The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. • Like the DOL, DFL can be calculated in two different ways: One calculation will give you a point estimate, the other will yield an interval estimate of DFL. • Only companies that use debt or other forms of fixed cost financing (like preferred stock) will experience financial leverage. *兩種fixed financing costs: interest expense與preferred stock dividend

21. Operating & Financial Leverage Degree of Financial Leverage 注意：若有特別股存在，則這裡要再減去特別股股利

22. Operating & Financial Leverage Degree of Financial Leverage Interval Estimate of DFL DFL = % Change in EPS = 46.67% = 1.33 % Change in EBIT 35.00% In this case, the DFL is greater than 1 which indicates the presence of debt financing. In general, the greater the DFL, the greater the financial leverage and the greater the financial risk.

23. Operating & Financial Leverage Degree of Financial Leverage Point Estimate of DFL DFL = EBIT = 80 = 1.33 EBIT - Interest 80 - 20 DFL = EBIT = 108 = 1.23 EBIT - Interest 108 - 20 In this case, we can see that the DFL is related to the expected level of EBIT. However, the DFL declines if the firm performs better than expected. Note also, however, that the DFL will rise if the firm performs worse than expected. 若有preferred stock，則公式為

24. Operating & Financial Leverage Degree of Total Leverage

25. Operating & Financial Leverage Degree of Total Leverage Interval Estimate of DTL DTL = % Change in EPS = 46.7% = 4.67 % Change in Sales 10% In this case, the DTL is greater than 1 which indicates the presence of both fixed operating and fixed financing costs. In general, the greater the DTL, the greater the financial leverage and the greater the operating leverage.

26. Operating & Financial Leverage Degree of Total Leverage Point Estimate of DTL DTL = DOL x DFL = Q x (P - VC) x EBIT = Q x (P-VC) Q x (P-VC) - FC EBIT– I - [PD/(1-t)] EBIT- I - [PD/(1-t)] DTL = 700 – 420 = 4.67 700 - 420 - 200 - 20 - 0 At our base level of sales of 700, the point estimate gives us the same result we obtained using the interval estimate.

27. Operating & Financial Leverage Degree of Total Leverage The relationship between the DTL, DOL, and DFL is illustrated in the following equation: DTL = DOL x DFL Applying this to our example at a sales level of $770, we get: DTL = 3.50 x 1.33 = 4.6 Which is the same result we obtained using either the point or interval estimates at that sales level.

28. The Firm’s Capital Structure • Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. • Poor capital structure decisions can result in a high cost of capital, thereby lowering project NPVs and making them more unacceptable. • Effective decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of the firm.

29. Types of Capital

30. Internal Assessment of Capital Structure High business risk industry tends to maintain a lower financial risk Lower business risk industry tends to have a higher financial risk

31. Capital Structure of Non-U.S. Firms • In recent years, researchers have focused attention not only on the capital structures of U.S. firms, but on the capital structures of foreign firms as well. • In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. • In most European and Pacific Rim countries, large commercial banks are more actively involved in the financing of corporate activity than has been true in the U.S.

32. Capital Structure of Non-U.S. Firms • Furthermore, banks in these countries are permitted to make large equity investments in non-financial corporations -- a 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.

33. Capital Structure Theory MM [ Modigliani and Miller(1958)]: capital structure irrelevancy • According to finance theory, firms possess a target capitalstructure that will minimize its cost of capital. • Unfortunately, theory can not yet provide financial mangers with a specific methodology to help them determine what their firm’s optimal capital structure might be. • Theoretically, however, a firm’s optimal capital structure will just balance the benefits of debt financing against its costs.

34. Capital Structure Theory • The major benefit of debt financing is the tax shield provided by the federal government regarding interest payments. • The costs of debt financing result from • the increased probability of bankruptcy caused by debt obligations, • the agency costs resulting from lenders monitoring the firm’s actions, and • the costs associated with the firm’s managers having more information about the firm’s prospects than do investors (asymmetric information).

35. Capital Structure Theory Tax Benefits • Allowing companies to deduct interest payments when computing taxable income lowers the amount of corporate taxes. • This in turn increases firm cash flows and makes more cash available to investors. • In essence, the government is subsidizing the cost of debt financing relative to equity financing.

36. Capital Structure Theory Probability of Bankruptcy • The probability that debt obligations will lead to bankruptcy depends on the level of a company’s business risk and financial risk. • Business risk is the risk to the firm of being unable to cover operating costs. • In general, the higher the firm’s fixed costs relative to variable costs, the greater the firm’s operating leverage and business risk. • Business risk is also affected by revenue and cost stability. (1) (2) (3)

37. Capital Structure Theory Probability of Bankruptcy • The firm’s capital structure - the mix between debt versus equity - directly impacts financial leverage. • Financial leverage measures the extent to which a firm employs fixed cost financing sources such as debt and preferred stock. • The greater a firm’s financial leverage, the greater will be its financial risk - the risk of being unable to meet its fixed interest and preferred stock dividends.

38. Capital Structure Theory Agency Costs Imposed by Lenders • When a firm borrows funds by issuing debt, the interest rate charged by lenders is based on the lender’s assessment of the risk of the firm’s investments. • After obtaining the loan, the firm (stockholders/managers) could use the funds to invest in riskier assets. • If these high risk investments pay off, the stockholders benefit but the firm’s bondholders are locked in and are unable to share in this success.

39. Capital Structure Theory Agency Costs Imposed by Lenders • To avoid this, lenders impose various monitoring costs on the firm. • Examples of these monitoring costs would include: • raising the rate on future debt issues, • denying future loan requests, • imposing restrictive bond provisions.

40. Capital Structure Theory Pecking order • (1)Retained earnings • (2)Debt • (3)Equity

41. Note: Agency Costs Imposed by Stockholders • As firms issue more stock, the ownership becomes more diffused and therefore separated from management. • Manager has incentives to consume more perks and work less. • This will hurt the stockholders. • To avoid this, stockholders impose various monitoring costs on the firm. • Examples of these monitoring costs would include: • establishing a more efficient director board, e.g., outside director • pressure from the SEC and CPA to closely monitor the management, • asking for more cash dividends.

42. Capital Structure Theory Asymmetric Information • Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. • Asymmetric information can impact the firm’s capital structure as follows: Suppose management has identified an extremely lucrative investment opportunity and needs to raise capital. Based on this opportunity, management believes its stock is undervalued since the investors have no information about the investment.

43. Capital Structure Theory Asymmetric Information • Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. • Asymmetric information can impact the firm’s capital structure as follows: In this case, management will raise the funds using debt since they believe/know the stock is undervalued (underpriced) given this information. In this case, the use of debt is viewed as a positive signal to investors regarding the firm’s prospects.

44. Capital Structure Theory Asymmetric Information • Asymmetric information results when managers of a firm have more information about operations and future prospects than do investors. • Asymmetric information can impact the firm’s capital structure as follows: On the other hand, if the outlook for the firm is poor, management will issue equity instead since they believe/know that the price of the firm’s stock is overvalued (overpriced). Issuing equity is therefore generally thought of as a “negative” signal.

45. The Optimal Capital Structure So What is the Optimal Capital Structure? • In general, it is believed that the market value of a company is maximized when the cost of capital (the firm’s discount rate) is minimized. • The value of the firm can be defined algebraically as follows: V = EBIT (1 - t) ka 假設zero growth model ka為WACC

46. The Optimal Capital Structure So What is the Optimal Capital Structure? • 股東每年所享有之現金流量 • 假設不成長，則Dep=CE，且NWC=0 • ∴上式=EBIT(1-)-Int(1- )-PR • 至於債權人每年所享有之現金流量=Int(1- )+PR，所以整個公司每年的現金流量= EBIT(1-) • It can be described graphically as shown on the following two slides. PR=本期攤還之本金 Dep=折舊費用 C.E.=資本支出=今年的機器廠房等固定資產比去年增加的部份 NWC=淨營運資金之改變

47. The Optimal Capital Structure Kd比ke低是因為tax shield以及求償權 當D/A=0時，WACC=ke。隨著(D/A) 時kd所佔的比重也愈來愈大，但因為kd<ke，所以wacc一開始會下降 Ke Graphically Cost of equity Cost (%) =ka WACC Ke Why 先下降再上升? Kd 為稅後的cost of debt Kd 0 Target Capital Structure TD/TA (%)

48. The Optimal Capital Structure Graphically Firm Value ($) V = EBIT (1 - t) ka V($) 0 Target Capital Structure TD/TA (%)

49. The Optimal Capital Structure • An example of how this might work using actual numbers is demonstrated below:

50. The Optimal Capital Structure