Foundations of Finance Arthur Keown John D. Martin J. William Petty

1. Foundations of Finance Arthur Keown John D. Martin J. William Petty

2. Determining the Finance Mix Chapter 12

3. Learning Objectives • Understanding the difference between 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. • Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage. • Understand the concept of an optimal capital structure. Keown Martin Petty - Chapter 12

4. Learning Objectives • Explain the main underpinnings of capital structure theory. • Understand and be able to graph the moderate position on capital structure importance. • 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. Keown Martin Petty - Chapter 12

5. Slide Contents • Principles Used in this chapter • Risk • Break-even Analysis • Operating and Financial leverage • Planning the Financing Mix • Capital Structure Theory • Capital Structure Management (Basic Tools) • Capital Structure Management (Survey Results) • Finance and the Multinational Firm Keown Martin Petty - Chapter 12

6. 1. Principles Used in this Chapter

7. 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 Keown Martin Petty - Chapter 12

8. 2. Risk

9. Risk • The variability associated with expected revenue or income streams. Such variability may arise due to: • Choice of business line (business risk). • Choice of an operating cost structure (operating risk). • Choice of capital structure (financial risk). Keown Martin Petty - Chapter 12

10. Business Risk • Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk: • The stability of the domestic economy • The exposure to, and stability of, foreign economies • Sensitivity to the business cycle, and • Competitive pressures in the firm’s industry. Keown Martin Petty - Chapter 12

11. Operating Risk • Operating risk is the variation in the firm’s operating earnings that results from the firm’s cost structure (mix of fixed and variable operating costs). • Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues. Keown Martin Petty - Chapter 12

12. Financial Risk • Financial Risk is the variation in earnings as a result ofafirm’s financing mix or proportion of financing that requires a fixed return. Keown Martin Petty - Chapter 12

13. 3. Break-even Analysis

14. Break-even Analysis • Break-even analysis is used to determine the break-even quantity of a firm’s 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. Break-even point indicates the point of sales or units at which EBIT is equal to zero. Keown Martin Petty - Chapter 12

15. 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. Keown Martin Petty - Chapter 12

16. Elements of Break-even Model • Break-even analysis requires information on the following: • Fixed Costs • Variable Costs • Total Revenue • Total Volume Keown Martin Petty - Chapter 12

17. Break-even analysis requires classification of costs into two categories: • Fixed costs or indirect costs • Variable costs or direct costs • Since all costs are variable in the long-run, break-even analysis is a short-run concept. Keown Martin Petty - Chapter 12

18. Fixed or Indirect Costs • These costs do not vary in total amount as sales volume or the quantity of output changes. • 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). • Fixed costs vary per unit but remain fixed in total. • The total fixed costs are generally fixed for a specific range of output. Keown Martin Petty - Chapter 12

19. Fixed Costs Examples: • Administrative salaries • Depreciation • Insurance • Lump sums spent on intermittent advertising programs • Property taxes • Rent Keown Martin Petty - Chapter 12

20. Variable or Direct Costs • Variable costs vary as output changes. Thus if production is increased by 5%, total variable costs will also increase by 5%. • Total variable costs = VC x N • Where VC = Variable cost per unit • N = # of units produced and sold Keown Martin Petty - Chapter 12

21. Variable Costs Examples: • Direct labor • Direct materials • Energy costs (fuel, electricity, natural gas) associated with the production • Freight costs • Packaging • Sales commissions Keown Martin Petty - Chapter 12

22. Keown Martin Petty - Chapter 12

23. Revenue • Total revenue is the total sales dollars • Total Revenue = P x Q • P = selling price per unit • Q = quantity sold Keown Martin Petty - Chapter 12

24. Volume • The volume of output refers to the firm’s level of operations and may be indicated either as a unit quantity or as sales dollars. Keown Martin Petty - Chapter 12

25. Break-even Point (BEP) • BEP = Point at which EBIT equals zero • EBIT = (Sales price per unit) (units sold) – [(variable cost per unit) (units sold) + (total fixed cost)] Keown Martin Petty - Chapter 12

26. Break-even Point (BEP) • BEP (Units) = Total Fixed costs (Unit sales price – Unit variable cost) • BEP (dollars) = Total Fixed Costs 1 – Variable cost/sales price Keown Martin Petty - Chapter 12

27. Example • Selling price per unit is $12; Variable cost per unit is $6; Fixed costs are $120,000 • BEP (units) = $120,000/ ($12-$6) = $120,000/$6 = 20,000 units • If the firm sells 20,000 units, EBIT will be equal to zero. Keown Martin Petty - Chapter 12

28. Example • BEP (in dollars) = 120,000 1 – 12/6 = 120,000/.5 = $240,000 • At sales of $240,000, EBIT will be equal to zero. Keown Martin Petty - Chapter 12

29. BEP for Pierce Grain Company Keown Martin Petty - Chapter 12

30. Example • Selling price = $10 per unit • Variable cost = $6 per unit • Fixed cost = $100,000 • BEP (Units) = Total Fixed costs (Unit sales price – Unit variable cost) = 100000/4 = 25000 units Keown Martin Petty - Chapter 12

31. Example • BEP (dollars) = Total Fixed Costs 1 – Variable cost/sales price • BEP (in $ revenues) = $100,000/.4 =$250,000 • (1-180000/300000) = 1 - .6 = .4 Keown Martin Petty - Chapter 12

32. 4. Operating and Financial Leverage

33. Operating Leverage • Operating leverage measures the sensitivity of the firm’s EBIT to fluctuation in sales, when a firm has fixed operating costs. • If the firm has no fixed operating costs, EBIT will change in proportion to the change in sales. Keown Martin Petty - Chapter 12

34. Operating Leverage • Operating Leverage (OL) = % change in EBIT % change in sales • Thus % change in EBIT = OL X % change in sales Where : % change in EBIT = EBITt1 – EBITt / EBITt % Change in sales =Salest1 – Salest / Salest Keown Martin Petty - Chapter 12

35. 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 = 5% x 6 = 30% Thus if the firm increases sales by 5%, EBIT will increase by 30% Keown Martin Petty - Chapter 12

36. 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 in response to change in sales. Keown Martin Petty - Chapter 12

37. Operating Leverage for Pierce Grain Keown Martin Petty - Chapter 12

38. Operating Leverage for Pierce Grain • Due to operating leverage, even though the sales increase by only 20%, EBIT increases by 120%. (and vice versa, if sales dropped by 20%, EBIT will fall by 120%; see next slide) • If Pierce had no operating leverage (i.e. all of its operating costs were variable), then the increase in EBIT would have been in proportion to increase in sales, i.e. 20%. Keown Martin Petty - Chapter 12

39. Keown Martin Petty - Chapter 12

40. Financial Leverage • Financial leverage is financing a portion of the firm’s assets with securities bearing a fixed rate of return in hopes of increasing the return to the common stockholders. • Thus, the decision to use preferred stock or debt exposes the common stockholders to financial risk. • Variability of EBIT is magnified by firm’s use of financial leverage. Keown Martin Petty - Chapter 12

41. Three financing plans for Pierce Grain Keown Martin Petty - Chapter 12

42. Three financing plans for Pierce Grain • Plan A: 0% debt – no financial risk • Plan B: 25% debt – moderate financial risk • Plan C: 40% debt – higher financial risk • See next slide for impact of financial leverage on earnings per share (EPS). The use of financial leverage magnifies the impact of changes in EBIT on earnings per share. Keown Martin Petty - Chapter 12

43. Keown Martin Petty - Chapter 12

44. A firm is employing financial leverage and exposing its owners to financial risk when: • Percentage change in EPS divided by Percentage change in EBIT is greater than 1.00 Keown Martin Petty - Chapter 12

45. Combined Leverage • Operating leverage causes changes in sales revenues to cause even greater changes in EBIT; furthermore, changes in EBIT due to financial leverage create large variations in both EPS and total earnings available to common shareholders. • Not surprisingly, combining operating and financial leverage causes rather large variations in EPS Keown Martin Petty - Chapter 12

46. Combined Leverage • Combined Leverage = Percentage change in EPS/Percentage change in sales • Or combined leverage = Operating Leverage X Financial Leverage • See table 12-6 Keown Martin Petty - Chapter 12

47. Combining Operating and Financial Leverage Keown Martin Petty - Chapter 12

48. 5. Planning the Financing Mix

49. Capital 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 Keown Martin Petty - Chapter 12

50. Financial Structure • Designing a prudent financial structure requires answers to the following: 1. How should a firm best divide its total fund sources between short- and long-term components? 2. Capital structure management: In what proportions relative to the total should the various forms of permanent financing be utilized? • This chapter focuses on the second question. Keown Martin Petty - Chapter 12