Chapter 12 – The Financing Mix

1. Chapter 12 – The Financing Mix • Key Sections: • Business and Financial Risk • Operating, financial and combined leverage • Capital structure and financial structure • Saucer-shaped cost of capital curve • Management practices

2. Risk • Variability in revenue or income streams • Business risk affects EBIT • Results from investment decisions (cost structure, competition, price elasticity, etc) • Financial risk – use of fixed rate financing sources • Variation in net income is due to both business and financial risk

3. Sources of Risk • Risk results from the presence of fixed costs • Fixed operating and financing costs • If present, what happens to EBIT and EPS if sales change? • EBIT will change more than sales change with fixed operating costs • Changes in EPS will be even greater than the change in EBIT if fixed-rate financing used

4. Breakeven Analysis • Find amount of sales to produce EBIT of zero • Variable or direct costs vary as output changes but are fixed per unit • Example: raw material costs • Fixed costs do not vary as sales change • Example: depreciation • Semi variable (over a range of output)

5. Contribution Margin Per unit sales price $12 Variable cost per unit -7 Unit contribution margin 5 • Unit sales price less unit variable cost equals contribution margin (left over to cover fixed costs)

6. Percentage Change • Percentage change = New Value less Old OldValue • Increase from 100 to 200 = 100% increase (200 – 100) / 100 = 100% • Decrease from 200 to 100 = 50% decrease (100 - 200) / 200 = -.5 = -50%

7. Leverage • In finance – presence of fixed operating costs and/or fixed financing costs cause sale changes to have a magnified impact on EBIT and EPS • Degree of Operating Leverage (DOL) = • % change in EBIT divided by sales change • Pierce +120% in EBIT/ +20% sales = 6 times

8. Degree of Operating Leverage 2003 2004 • Sales 300 360 +20% • Less: Variable Costs -180-216 • Revenue before fixed 120 144 • Less: Fixed -100 -100 • EBIT 20 44 120% • DOL = %Δ EBIT = 120% = 6 times %Δ Sales 20%

9. Implications of DOL • With DOL of 6 times, if sales increase 20%, EBIT will change by 120% (because the fixed costs don’t change) • If sales fall 20% EBIT will decline 120% resulting in a $4,000 operating loss • DOL falls as sales increase because fixed costs are spread over more units

10. Financial Leverage • Financing a portion of the assets with fixed-rate financing (bonds, preferred stock) • Degree of Financial Leverage = % change in EPS/ % change in EBIT, say 1.25 times • Shows responsiveness of EPS to changes in EBIT • Can have positive or negative effects but with greater leverage, greater changes occur

11. Degree of Financial Leverage DFL 20032004 EBIT 20 44 +120% Less: Interest -4-4 Before tax 16 40 Tax @ 50% -8-20 Net Income 8 20 +150% DFL = %Δ Net Inc = 150% = 1.25 times %Δ EBIT 120%

12. Combined Leverage • With operating leverage, changes in revenue cause greater changes in EBIT. With financial leverage, EBIT changes result in greater EPS changes • Combining these: sales change magnifies EPS change • DCL = % change in EPS/ % change in Sales • And DCL = DOL multiplied by DFL

13. Combined Leverage 2003 2004 Sales 300 360 +20% Net Income 8 20 +150% DCL = %Δ Net Inc. = 150% = 7.50 times %Δ Sales 20 Also = DOL * DFL = 6 X * 1.25X = 7.50 X

14. Implications • Total risk can be managed by combining DOL and DFL in differing degrees • If have high DOL (fixed costs) it may be appropriate to use lower DFL • If have low fixed operating costs, can tolerate more financial risk to increase returns

15. Planning the Financing Mix • Financial structure – all items on right side • Capital structure – all long-term sources • Questions: short/long mix, how much from each? • Maturity – influenced by nature of assets Long-term assets + permanent part of working capital require long-term financing • Objective – minimize composite cost

16. Capital Structure Theory • Can we affect cost by changing mix? • Independence (Modigliani) – “no” • But assumptions may be unrealistic • Moderate view – more realistic • Considers taxes and bankruptcy risk • Debt encouraged by tax shield • Causes C of C to fall but only to a point

17. Optimal Capital Structure • Where Cost of Capital is minimized • Also called debt capacity – point where costs begin to increase • More debt, likelihood of failure increases • At a point, default risk outweighs tax shield • Cost curve – declines with added debt Minimum cost points = optimal structure

19. Saucer-Shaped Curve (Moderate) • Before bankruptcy costs become detrimental, the tax shield causes share price to increase/ cost of capital to fall • Need to find the optimal range of leverage • Use caution in using fixed-charge capital, especially if there is operating leverage.

20. Summary of Financial Leverage • Added variability in EPS • More leverage causes large changes (favorable and unfavorable) in EPS for a given EBIT change. • EBIT, EPS and Capital Structure • Above some EBIT level, EPS will be higher with leverage but there is a debt limit

21. Management Practices • Management sets debt targets based on evaluation of business risk (sales and EBIT variability). Influenced by • Desired bond rating • Having a borrowing reserve • Advantage of leverage • Unwise to use large amounts of leverage with an uncertain income stream.