Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.

1. Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr. Chapter 12 Determining the Finance Mix

2. Learning Objectives • Understanding the difference between business risk and financial risk. • Use the technique of break-even analysis in a variety of analytical settings. • Distinguish among the financial concepts of operating leverage, financial leverage, and combined leverage. Foundations of Finance

3. Learning Objectives • Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage. • Understand the concept of an optimal capital structure. • Explain the main underpinnings of capital structure theory. • Understand and be able to graph the moderate position on capital structure importance. Foundations of Finance

4. Learning Objectives • Incorporate the concepts of agency costs and free cash flow into a discussion on capital structure management. • Use the basic tools of capital structure management. • Understand how business risk and global sales impact the multinational firm. Foundations of Finance

5. Principles Used in this Chapter • Principle 1: The Risk-Return Tradeoff – We Won’t Take on Additional Risk Unless We Expect to Be Compensated With Additional Return. • Principle 3: Cash-Not Profits-Is King • Principle 7: The Agency Problem –Managers Won’t Work for the Owners Unless It’s in Their Best Interest • Principle 8: Taxes Bias Business Solutions Foundations of Finance

6. Risk • Risk: Likely variability associated with expected revenue or income streams • Business Risk: Relative dispersion (variability) in the firm’s expected earnings before interest and taxes (EBIT) Foundations of Finance

7. Risk Financial Risk: a direct result of the firm’s financing decision. • the additional variability in earnings available to the firm’s common shareholders • the additional chance of insolvency borne by the common shareholder caused by the use of financial leverage Foundations of Finance

8. Leverage • Financial Leverage: Financing a portion of the firm’s assets with securities bearing a fixed (limited) rate of return in hopes of increasing the ultimate return to the common stockholders. • Operating leverage: Incurrence of fixed operating costs in the firm’s income stream. Foundations of Finance

9. Break-even Analysis • Determine the break-even quantity of output by examining the relationships among the firm’s cost structure, volume of output, and profit. • Break-even may be calculated in units or sales dollars Foundations of Finance

10. Break-even Analysis Use of break-even model enables the financial officer: • To determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs • To calculate the EBIT that will be achieved at various output levels Foundations of Finance

11. Elements of Break-even Break-even is a short run concept: • Fixed costs or indirect costs • Variable costs or direct costs • Revenue • Volume Foundations of Finance

12. Fixed Costs • Indirect Costs • Do not vary in total amount as sales volume or the quantity of output changes over some relevant range of output. • As production volume increases, fixed costs per unit of product falls, as fixed costs are spread over a larger and larger quantity of output (but total remains the same.) • Vary per unit but remain fixed in total Foundations of Finance

13. Fixed Costs Examples: • Administrative salaries • Depreciation • Insurance • Lump sums spent on intermittent advertising programs • Property taxes • Rent Foundations of Finance

14. Variable Costs • Direct Costs • Fixed per unit of output but may vary in total as output changes • Total variable costs are computed by taking the variable cost per unit and multiplying it by the quantity produced and sold Foundations of Finance

15. Variable Costs Examples: • Direct labor • Direct materials • Energy costs (fuel, electricity, natural gas) associated with the production area • Freight costs • Packaging • Sales commissions Foundations of Finance

16. Revenue and Volume • Total Revenue • Total sales dollars • Equal to the selling price per unit multiplied by the quantity sold • Volume of output • Firm’s level of operations • May be indicated either as a unit quantity or as sales dollars Foundations of Finance

17. Break-even Point (Sales price per unit) (units sold) – [(variable cost per unit) (units sold) + (total fixed cost)] = EBIT Must find the number of units that must be produced and sold in order to satisfy EBIT=0 Foundations of Finance

18. Break-even Point Two approaches: • Contribution-margin analysis • Algebraic analysis Foundations of Finance

19. Contribution-margin analysis The difference between the unit selling price and unit variable costs: Unit sales price - Unit variable cost = Unit contribution margin Foundations of Finance

20. Problem • Selling price per unit is $10 • Variable cost per unit is $6 • Fixed costs are $100,000 • What is breakeven? Foundations of Finance

21. Problem • Total fixed costs/unit contribution margin= Break-even quantity • $100,000/ ($10-$6) = Break-even • $100,000/$4= 25,000 Foundations of Finance

22. Algebraic Approach (P x Q) – [(V x Q) +(F)] = $0 (P x Q) – (V x Q) – F = 0 Q (P-V) = F Qb = F/(P-V) Where: Q = units sold P = Sales price Qb = break even level of quantity F = Fixed Costs V = Variable Costs $100,000 / (10 – 6) = 25,000 Foundations of Finance

23. Example Sales $ 300,000 Var costs 180,000 Revenue 120,000 Fixed Costs 100,000 EBIT $ 20,000 Per unit sales price is $10 Per unit variable cost is $6 Foundations of Finance

24. Break-even in Dollars S = Fixed costs / [1 – (Var costs/sales)] 100,000/ [1 – (180,000/300,000)] BE in dollars = $250,000 BE in units is 25,000 @ $10 = $250,000 Foundations of Finance

25. Operating Leverage • Responsiveness of the firm’s EBIT to fluctuation in sales • How will a company respond to a percentage change in sales? • Percentage change in EBIT / Percentage change in sales Foundations of Finance

26. Operating Leverage • Percentage change in EBIT / Percentage change in sales Percentage change in EBIT = (EBITt1– EBITt) / EBITt Percentage Change in sales = (Salest1– Salest) / Salest Foundations of Finance

27. Operating Leverage Example : If a company has an operating leverage of 6, then what is the change in EBIT if sales increase by 5%? Percentage change in EBIT = Operating leverage X Percentage change in sales Percentage change in EBIT = 5% x 6 or 30% If the firm increases sales by 5%, EBIT will increase by 30% Foundations of Finance

28. Alternative Operating Leverage Calculation • DOL = Revenue before fixed costs / EBIT or • DOL = (Sales – Variable costs) / (Sales – Variable costs – Fixed costs) Foundations of Finance

29. Operating Leverage Operating leverage is present when: • Percentage change in EBIT / Percentage change in sales > 1.00 • The greater the firm’s degree of operating leverage, the more the profits will vary with a given percentage of sales Foundations of Finance

30. Financial Leverage • Financing a portion of the firm’s assets with securities bearing a fixed rate of return • A firm is employing financial leverage and exposing its owners to financial risk when: • Percentage change in EPS / Percentage change in EBIT > 1.00 • Measured by Percentage change in EPS / Percentage change in EBIT Foundations of Finance

31. Combining Operating Leverage and Financial Leverage • Changes in sales revenues cause greater changes in EBIT; changes in EBIT create larger variations in both EPS and total earnings available to common shareholders, if the firm chooses to use financial leverage. • Combining operating and financial leverage causes rather large variations in EPS • Percentage change in EPS/Percentage change in sales • Operating Leverage X Financial Leverage = Combined Leverage Foundations of Finance

32. Combined Leverage • DOL X DFL = DCL or • DCL= [Q (P-V)] / [Q(P-V) – F – I] Foundations of Finance

33. Structure • Financial Structure • Mix of all items that appear on the right-hand side of the company’s balance sheet • Capital Structure • Mix of the long-term sources of funds used by the firm • (Financial Structure) – (Current liabilities) = Capital Structure Foundations of Finance

34. Financial Structure Requires answers to: 1. How should a firm best divide its total fund sources between short- and long-term components? 2. In what proportions relative to the total should the various forms of permanent financing be utilized? Foundations of Finance

35. Capital Structure Theory • The effect of financial leverage on the overall cost of capital to the enterprise • Can the firm affect its overall cost of funds, either favorably or unfavorably, by varying the mixture of financing used? • Firms strive to minimize the cost of using financial capital Foundations of Finance

36. Firm Failure – Bankruptcy • Threat of financial distress causes the cost of debt to rise • As financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield of debt financing Foundations of Finance

37. Debt Capacity • Maximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital. Foundations of Finance

38. Agency Costs To ensure that agent-managers act in shareholders best interest, firms must: 1. Have proper incentives 2. Monitor decisions -bonding the managers -auditing financial statements -structuring the organization in unique ways that limit useful managerial decisions -reviewing the costs and benefits of management perquisites The costs of the incentives and monitoring must be borne by the stockholders. Foundations of Finance

39. Capital Structure Management and Agency Costs • The firm’s stockholders are affected by capital structure decisions • Capital structure management gives rise to agency costs. • Agency problems stem from conflicts of interest • Capital structure management encompasses a natural conflict between stockholders and bondholders. Foundations of Finance

40. Cost of Capital-Capital Structure Relationship • Interest expense is tax deductible • Probability of bankruptcy directly related to the use of financial leverage • Because interest is deductible, the use of debt financing should result in higher total market value for firms outstanding securities Tax Shield = rd(m)(t) r = rate, m = principal, t = marginal tax rate Foundations of Finance

41. Target Debt Ratios • An influence of the level of target debt ratio is the ability to meet financing charges. Also • Maintaining a desired bond rating • Providing an adequate borrowing reserve • Exploiting the advantages of financial leverage Foundations of Finance

42. Debt Capacity • As defined by executives in a survey, the most popular approach was as a target percentage of total capitalization Foundations of Finance

43. Business Risk • Single most important factor that should affect the firm’s financing mix is the underlying nature of the business in which it operates. Foundations of Finance

44. The Multinational Firm Business risk is multidimensional and international and is affected by: • The sensitivity of the firm’s product demand to general economic conditions • The degree of competition to which the firm is exposed • Product diversification • Growth prospects • Global sales volumes and production output Foundations of Finance